Foreign capital has flowed largely to small private and semi-private enterprises enterprises that are often nominally collectively owned but in fact merely wear a "red hat" for political reasons engaged in labor-intensive production of "traditional" Chinese exports. Because these enterprises normally find themselves in weak bargaining positions, they generally must trade equity for relatively small amounts of capital, with the result that China's ineffective domestic capital market has forced Chinese entrepreneurs to "sell" out to foreign control.
By , the process of foreign takeover had progressed to the point that foreign invested enterprises FIEs accounted for a third of China's total exports and over half of its exports of industrial goods. Despite its privileged position in China's political pecking order, the state sector has also fallen victim to foreign buyouts. Easy access to state bank funds combined with a deeply set institutional bias toward technological upgrading and large-scale production led state-owned enterprises SOEs to invest heavily in new assets during the s.
Inefficiency and a failure to adapt to emerging market forces, however, caused SOE profits to contract. As profits fell, enterprises [End Page ] continued to borrow heavily from the state-owned banks, thus causing their debt-service requirements to mount and further squeeze profits. By the time FDI regulations were liberalized in the wake of Deng Xiaoping's Southern Tour, an increasingly large percentage of SOEs were on the brink of insolvency and became, according to Huang, attractive takeover objects.
Unwilling to allow extensive privatization, the Chinese Communist Party CCP continued to bar acquisitions by more efficient enterprises in the nonstate sector and thereby forced SOEs to enter into "joint ventures" with foreign investors wherein the Chinese side de facto sold their assets in return for short-term capital bailouts and traded operational control for a share of future profits.
Many SOEs thus became holding companies, while their operating subsidies came under foreign control. This resulted, Huang concludes, in a large-scale program of informal privatization. But informal privatization came at a high price to the Chinese economy, in his view, because the best corporations and their assets were frequently sold at fire-sale prices to foreigners while Chinese entrepreneurs were denied the opportunity to bid for these valuable economic resources.
Despite his focus on FDI and China's domestic capital market, in the end Huang's book is about economic nationalism. In the name of preserving socialism by rejecting privatization, he argues, the Chinese Communist Party has sold a substantial portion of the Chinese economy to foreigners.
Huang in fact evokes the image of the Opium War in his conclusion, suggesting that China might be headed for another "century of humiliation" at the hands of foreigners p. He thus suggests that China's "reformers" were not so much "selling" China in the sense of selling it as an attractive investment; they were "selling out" China in that their desire to hold the political line led them to sell off the commanding heights of the Chinese economy—and not just of the state sector but also of the nonstate sector.
Project MUSE promotes the creation and dissemination of essential humanities and social science resources through collaboration with libraries, publishers, and scholars worldwide. Forged from a partnership between a university press and a library, Project MUSE is a trusted part of the academic and scholarly community it serves. Although not separate customs areas and less independent than SEZs, OCCs have enjoyed greater flexibility in investment and tax policies than other regions in China.
HTDZs emerged in the early s. In most features similar to ETDZs, HTDZs have placed particular emphasis on attracting investment in high technology industries by providing additional tax concessions. The first two FTAs were established in the early s in Pudong and Shenzhen, and a number of others have been opened since then. Exports and imports can be traded freely within FTAs and enterprises are free to engage in bonded entrepot trade as well as export-oriented production.
China has extensively but selectively used tax incentives to guide FDI into designated regions, economic sectors and industries. Foreign-funded enterprises FFEs enjoy exemptions and reductions in the national business income tax and other incentives including exemptions of custom duties and the value-added tax for imported equipment and technology, exemptions and reductions in local business income tax, full refunds for income tax paid on reinvested earnings, and no restrictions on profit remittances and capital repatriation.
Also, the tax incentives are more favorable for technology and export-oriented FFEs. In , China adopted a new taxation system which unifies the taxation treatment of domestic enterprises and FFEs. At the same time, China decided to reduce gradually the preferential treatment for FFEs in order to establish a level playing field for both types of enterprises. With the implementation of this policy, the preferential policies, including tax incentives, will be gradually reduced and abolished. FFEs: 33 percent.
FFEs that export at least 70 percent of their annual output remain eligible for a 50 percent reduction after these five years. Advanced- technology FFEs receive a 50 percent reduction for 3 years after the initial 5 years. FFEs: 18 percent 1 and the same 2-year exemption, 3-year reduction as under the standard income tax regime. Export-oriented and advanced technology FFEs pay 10 percent instead of 15 percent after the initial 5-year exemption and reduction period has expired.
FFEs engaged in infrastructure projects in Hainan airports, harbors, docks, railroads, highways, power plants, and water conservation and with contracts for operating periods of 15 years or more are eligible for a 5-year exemption period followed by 5 years at a reduced rate 10 percent instead of 15 percent after the first profitable year.
FFEs: 27 percent 1 and the same 2-year exemption, 3-year reduction as under the standard income tax regime. FFEs: 18 percent 1 for all production-related FFEs, with the same 2-year exemption, 3-year reduction as under the standard income tax regime. FFEs: 18 percent 1 and the same exemptions and reductions as under the standard income tax regime for high or new technology enterprises.
OEZs have played a central role in the gradual opening of the economy to foreign investors. In the early reform period, one important difference between the OEZs and other areas in China was the administrative decentralization that permitted investment decisions in the OEZs to be taken largely outside the state plan. Local authorities in the OEZs were allowed to attract foreign investors through preferential policies.
They were also allowed to undertake their own infrastructure development and other investment as long as they could raise the funds from taxation, from profits of the enterprises they own wholly or partly, or from banks in the zones. Although the zones have provided favorable business conditions, a number of important constraints—such as restricted access to foreign exchange and domestic markets—remained in place in the early reform period.
This largely limited the business scope of foreign enterprises to export-oriented activities. When these restrictions were eased in the second half of the s, foreign investors gradually gained access to the domestic market and, as a result, links with the domestic economy increased. The international empirical evidence on the impact of preferential policies on FDI flows is mixed, and more work is needed to assess the impact in the case of China.
Reforms were initially confined to certain localities and FFEs and gradually extended more broadly. In this environment, the success of OEZs in China suggests that preferential policies were useful in catalyzing economic development and attracting FDI. In the absence of preferential policies, FDI would likely to have been substantially less, given the restrictive environment in which Chinese enterprises outside the OEZs had to operate.
Thus, it can be argued that preferential policies yielded a net gain to the economy—by allowing reforms to take hold and by attracting FDI which contributed to output growth. However, over time as the reform process advanced, preferential policies created distortions and inequities, particularly a complex and biased tax system and regional income disparities, that need to be addressed.
Shared cultural background. While many other countries do not share this characteristic, it could be argued that the large share of nonresident Chinese in FDI flows into China is a reflection of distortions rather than a unique advantage.
Cultural barriers, such as the language, which prevent foreign investors from entering China, could be a sign that the investment climate is too difficult for outsiders, which implies a cost. Corruption and legal environment. These are two important factors that have been found significant in explaining FDI to many countries. The ambiguity in the law has, in turn, contributed to corruption.
China scores relatively low on corruption and governance indicators in international comparisons Chart 5. Familiarity with the local culture helps in passing bureaucratic hurdles and that is one of the reasons why investors from Europe and the United States have often sought local counterparts. One study found that China could attract more FDI from Europe and the United States were it not for the implicit tax imposed by bureaucratic hurdles.
Output of FFEs in the industrial sector has expanded at four times the rate of other industrial enterprises during , while their labor productivity is almost two times that of public sector enterprises. In addition, empirical research has found that domestic enterprises appear to have benefited from the presence of FFEs, both through increased sales and positive spillovers.
These externalities are thought to have become progressively more important as more links began to develop between FFEs and domestic enterprises in the s. FDI has created employment opportunities. The creation of employment opportunities—either directly or indirectly—has been one of the most prominent impacts of FDI in China.
FFEs are particularly important employers in the coastal provinces, accounting for over 10 percent of urban employment in Guangdong, Fujian, Shanghai, and Tianjin as of FDI has built a highly competitive and dynamic manufacturing sector for exports. Between and , the share of exports accounted for by FFEs grew from 1 percent to 45 percent; FFEs accounted for half of overall export growth and one-third of import growth during this period.
Although part of the FDI flows from these economies may be induced by distortions, the fact remains that, together with Singapore, they have accounted for more than half of the FDI flows to China. Apart from the economic environment, political commitment is an important ingredient in attracting FDI.
It was shown, for example, that India shares with China many of the structural factors that have been important determinants of FDI—market size, abundant labor, and a large Indian Diaspora. So, a priori, there seems to be no reason why India could not become an attractive destination for FDI if it so chooses. There is of course a big difference in how political choices are made among countries.
In China, the political leadership imposed a vision for the path of growth and development of the country. Nevertheless, China had to overcome the obstacles to FDI rooted in history and ideology. The political leadership did so by limiting the opening to a few localities initially, but even then, a great deal of autonomy in economic decisions was given to the localities—allowing a market-based economy to develop alongside a centrally planned system.
Although this decentralization created some problems, it also gave local authorities strong incentives to grow and develop their economies. The success of the initial experiments created strong demonstration effects, which induced broad support for further reforms and opening up. This created a virtuous cycle as reforms produced economic fruits, support for reforms became more widespread, allowing more reforms to be implemented.
The effect is likely to be strongest if foreign enterprises develop close links with domestic enterprises, so that the impact of FDI on productivity growth is extended beyond the firms receiving FDI. WTO accession is expected to lead to a continuation of these contributions as FDI can be expected to increase, particularly in the services sector, such as finance, telecommunications, and wholesale and resale commerce.
FDI will continue to be an important source of growth and will help offset potential output losses and create employment opportunities for workers that have become redundant in state enterprise and banking reforms. It is significant that the Chinese authorities have invited foreign participation in the restructuring of state-owned enterprises and the resolution of the nonperforming loan problems in the banking sector.
In particular:. Chen C. Cheng L. Head K. Liu X. Song Y. Wei and P. Wall D B. Jiang and X. Wei S. Zhang K. A version of this paper was presented at a seminar held at the Department of Industrial Policy and Promotion in Delhi, India on November 12, Harrold and Lall , Lardy , and Wei Under an equity joint venture, Chinese and foreign investors operate the venture and share the risks, profits, and losses jointly.
All parties involved agree on the equity share of each party. Profits are distributed to the parties in proportion to their equity share. Both parties decide on the proportions in which products, revenue, and profits are distributed. A wholly foreign-owned venture is wholly owned by foreign investors. Cheng and Kwan and Liu et al. Cheng and Kwan , Liu et al. Zebregs and Zhang Cheng and Kwan , and Head and Ries Open economic zones include SEZs, open coastal cities, and various development zones.
For a taxonomy of the different types of zones see Box 1 and Wall, Jiang, and Jin Cheng and Kwan and Head and Ries It is difficult to measure the indirect employment effects of FDI; these include the employment indirectly generated as a result of spending by FFEs, or as a result of linkages of FFEs with domestic enterprises, either as competitors or as suppliers and customers.
User Account. IMF eLibrary. Advanced search Help. Kitts and Nevis St. Lucia St. Public Health Health Policy. Print Citation Alert off. Get Code Buy. This paper examines China's experience with FDI and identifies some lessons for other countries. Most of the factors explaining China's success have also been important in attracting FDI to other countries: market size, labor costs, quality of infrastructure, and government policies.
FDI has contributed to higher investment and productivity growth, and has created jobs and a dynamic export sector. China's success, however, did not come without some pitfalls: an increasingly complex tax incentive system and growing regional income disparities. Introduction II. Show Summary Details I. I ntroduction 1.
Table 1. Chart 1. China: FDI Inflows Table 2. Source: Statistical Yearbook of China. Chart 2. Chart 3. Chart 4. China: Forma of FDI. Table 3. Table 4. Economic Structure Table 5. China: Infrastructure Indicators Power Electric power consumption kwh per capita Source: World Bank, World Development indicators.
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Esther Shaulova. Contact Europe. Lodovica Biagi. Easy access to state bank funds combined with a deeply set institutional bias toward technological upgrading and large-scale production led state-owned enterprises SOEs to invest heavily in new assets during the s. Inefficiency and a failure to adapt to emerging market forces, however, caused SOE profits to contract.
As profits fell, enterprises [End Page ] continued to borrow heavily from the state-owned banks, thus causing their debt-service requirements to mount and further squeeze profits. By the time FDI regulations were liberalized in the wake of Deng Xiaoping's Southern Tour, an increasingly large percentage of SOEs were on the brink of insolvency and became, according to Huang, attractive takeover objects.
Unwilling to allow extensive privatization, the Chinese Communist Party CCP continued to bar acquisitions by more efficient enterprises in the nonstate sector and thereby forced SOEs to enter into "joint ventures" with foreign investors wherein the Chinese side de facto sold their assets in return for short-term capital bailouts and traded operational control for a share of future profits. Many SOEs thus became holding companies, while their operating subsidies came under foreign control.
This resulted, Huang concludes, in a large-scale program of informal privatization. But informal privatization came at a high price to the Chinese economy, in his view, because the best corporations and their assets were frequently sold at fire-sale prices to foreigners while Chinese entrepreneurs were denied the opportunity to bid for these valuable economic resources. Despite his focus on FDI and China's domestic capital market, in the end Huang's book is about economic nationalism.
In the name of preserving socialism by rejecting privatization, he argues, the Chinese Communist Party has sold a substantial portion of the Chinese economy to foreigners. Huang in fact evokes the image of the Opium War in his conclusion, suggesting that China might be headed for another "century of humiliation" at the hands of foreigners p.
He thus suggests that China's "reformers" were not so much "selling" China in the sense of selling it as an attractive investment; they were "selling out" China in that their desire to hold the political line led them to sell off the commanding heights of the Chinese economy—and not just of the state sector but also of the nonstate sector. Project MUSE promotes the creation and dissemination of essential humanities and social science resources through collaboration with libraries, publishers, and scholars worldwide.
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In specification I , pledged or contracted F D I is employed as the dependent variable. Pledged FDI inflows represent foreign firms' planned direct investment in China. They normally differ from actual F D I flows for any particular year not only because part of contracted FDI never materializes, but also because in many cases contracted FDI is to be realized over a period of several years.
This creates a time lag between the signing of a contract and the subsequent realizations of pledged amounts. The question of whether to use pledged or realized FDI as the dependent variable in the model specification is determined empirically in Sec- tion V. A few missing values for some observa- tions mainly from developing countries are extrapolated. To remove the influence of inflation, all variables except cultural differences, country risk and geographic distance are adjusted by the relevant price indexes.
Detailed information on the measurement of variables and sources of the data can be found in the Appendix. It has been argued that the official data on the nationality break- down of FDI in China can be somewhat biased, partly because of the multinationality of overseas Chinese investors, and partly because of pseudo-FDI by indigenous Chinese firms which team up with Chinese residents abroad to invest in China, thereby receiving the privileges and protection accorded to foreign investors see for example, Liu ; Harrold and Lall ; UNCTAD , This latter process is sometimes termed "round-tripping" investment.
Consequently, one must use a degree of caution when interpreting the empirical results. Empirical Results The three-step test outlined in Section III is carried out to select an appropriate statistical model. In the test for overall homogeneity step 1 , a calculated Fl-Statistic of 1. This indicates that the slopes and intercepts are not simultaneously homogeneous among different countries.
Unconditional pooling is not data-acceptable. The test of slope homogeneity step 2 gives a calculated F2-statistic of 1. Thus, the hypothesis of slope homogeneity is not rejected. The F3-statistic of 1. In addition, the total cultural differences and geographic distance variables included in 3 are time-invariant. Following the discussion of methodology in Section III, the combination of the inclusion of time-invariant variables and the three-step F-test results justifies the use of an error-components model for the given data.
Based on this statistical model, specifications I and II of equa- tion 3 are estimated using the generalized least squares GLS method. Specification I a is of the same form as 3 where pledged FDI is used as the dependent variable. In specification Ib those explanatory variables which are not significant in specification I a are excluded.
The results from specification I are generally consistent with expectations. In specification I a , the correctly signed and statisti- cally significant coefficients on relative wage rates, relative GDP, relative real exchange rates, and exports and imports indicate a strong economic relationship between these explanatory variables and pledged inward FDI in China.
This suggests that China's relatively cheaper labour force, its more rapidly expanding market, high degree of international integration with the outside world represented by its exports and imports and bilateral exchange rates are the four impor- tant economic determinants.
The borrowing costs variable has the wrong sign. The test result implies that the lower the borrowing costs in China, the greater will be inward FDI in China. This suggests that foreign businesses attempt to use not only their own, but also Chinese capital to finance their production in China. Therefore, the borrowing cost advantage on the part of the home country firm as one economic determinant of FDI is not supported by Chinese evidence.
Of course, since the coefficient on the borrowing cost variable is not statistically significant, we may simply say that this variable does not contribute significantly to the explanation of inward FDI in China. The country risk variable has the right sign but its coefficient is not statistically significant.
This may suggest that, while the Institutional Investor's ratings are a good indicator for credit risk assessment in the banking sector, they may not be the ideal proxy for country risk evaluation in relation to FDI. The coefficient on the cultural differences variable has the right sign and is statistically significant. This indicates the importance of cultural influences on inward FDI in China.
The coefficient on the geographic distance variable is statistically insignificant. An explanation is that the progress in communications and transport technologies allows better co-ordination of cross-bor- der activities so that geographic distance has become less and less important in international business. Thus, this variable does not enter into the explanation of FDI in China.
After removing these three variables, all the remain- ing explanatory variables are highly statistically significant at the 1 per cent significance level. The value of the unadjusted R 2 in this specification is only 0. Compared with specification I , specification II provides fewer correctly signed and statistically significant coefficients. While relative wage rates, exports and imports, and relative exchange rates remain important economic determinants of realized inward FDI in China, the relative market size variable has the wrong sign and is statistically insignificant.
This may indicate that while the rapidly expanding Chi- nese market attracts pledged inward FDI, actual inflows of pledged FDI are not correlated with these relative changes in the market size. As in the case of specification I , the coefficient on the borrowing cost variable has the wrong sign and is statistically insignificant in specification II , and the coefficient on the country risk variable has the right sign but is not statistically significant.
The cultural difference variable has the right sign as in specification I , but its coefficient is marginally insignificant with a probability of Finally, unlike specification I , the geographic distance variable now has the right sign, though its coefficient is still statistically insignificant. The empirical results from specifications I and II of equation 3 indicate that, while relative wage rates, relative exchange rates, and exports and imports are the common determinants of both pledged and realized FDI inflows in China, relative GDP and total cultural differences are the specific determinants of pledged FDI.
It is no surprise that pledged and actual FDI each have their own set of determinants, since the political, economic and cultural conditions under which FDI is planned are likely to be different from those under which FDI is realized. Conclusions In this paper, an error-components model of the determinants of pledged and realized inward FDI in China is estimated. The standard diagnostic tests show that this is an appropriate model. Therefore, the conclu- sions generated could be viewed as relatively general.
The results from estimation of the model support the hypotheses that inward FDI is determined by relative real wage rates, relative exchange rates, and economic integration represented by real exports and imports. In the case of pledged FDI in China, relative market size and total cultural differences are also two significant determinants.
Where appropriate, the explanatory variables are measured in relative terms on the grounds that rational investors would compare the home and host economic, political and cultural conditions before they un- dertake any FDI. The present analysis fails to support the hypotheses that relative borrowing costs, country risk and geographic distance influence in- ward FDI, since the coefficients on these variables are all statistically insignificant. This paper focuses on the relative home and host country charac- teristics.
Finn and industry-specific influences are beyond the scope of the current analysis. As suggested by Grosse and Trevino , the inclusion of firm and industry-specific factors may further enhance the explanatory power of the model. The findings from this study have an important implication for the future development of FDI in China. Rapid economic growth and foreign trade expansion are expected to continue, and labour costs are expected to remain competitive for the foreseeable future in China.
Therefore, China should expect to continue experiencing a rapid in- crease in inward FDI. Appendix 1. V a r i a b l e Definitions Variable Measurement and source of data! A better deflator is possibly the capital goods index as used in Moore , but a similar index the price index of investment in fixed assets is available for and only in China. RW The relative real wage rate, defined as the ratio of the change in real Chinese wage rates to real home country wage rates.
Source: Year- book of Labour Statistics. All wages are productivity-adjusted. The source of productivity for all other countries is the Interna- tional Financial Statistics Yearbook. Source: International Financial Statistics Yearbook. REX and China's real exports to, and real imports from, the home country. RBC Relative real borrowing costs defined as the ratio of China's real lending interest rate to the home country's real lending interest rate. Sources: International Financial Statistics Yearbook.
Hong Kong data is from the Monthly Statistical Bulletin. RCR Relative country risk defined as the ratio of annual country risk ratings for China to annual country risk ratings for the home country. The ratings are sealed from 0 to The higher the rating, the lower the chance of banking default.
Source: Institutional Investor. TCD This is the total cultural difference between China and the home country. Hofstede developed indices to measure four dimen- sions of cultural difference related to management. As constructed by Grosse and Goldberg and Grosse and Trevino , the total cultural difference is the sum of the absolute values of the four-dimensiondifferences. This measure is similar to the one developed by Kogut and Singh who divide the squares of the four-dimension differences by their variances and sum these values.
Since China was not in Hofstede's sample, we follow Pan and use the ratings for Taiwan as a surrogate measure for China. It is measured by the geographic distance between the home country's capital and China's capital Beijing. Source: Atlas of the World.
References Agarwal, J. Weltwirt- schaftliches Archiv 4 : Ajami, R. BarNiv Management International Review 24 4 : Aliber, R. A Theory of Foreign Direct Investment. Kindleberger ed. Cambridge, Mass. Baltagi, B. Econometric Analysis o f Panel Data. New York: John Wiley. Cantwell, J. A Survey of Theories of International Production. Pitelis and R. Sugden eds. London: Routledge. Culem, C. European Economic Review 32 4 : Cushman, D. Review of Economics and Statistics 67 2 : Southern Economic Journal 54 1 : Dielman, T.
Pooled Data for Financial Markets. Dunning, J. International Production and the Multinational Enterprise. Lon- don: Allen and Unwin. Explaining International Production. London: Unwin Hyman. Froot, K. Stein Quarterly Journal of Economics 4 : Grosse R. Goldberg Journal of Banking and Finance 15 6 : Grosse, R.
Trevino Journal of International Business Studies 27 1 : Harrold, P. Lall China's Reform and Development in World Bank Discussion Paper Washington D. Hofstede, G. London: Sage Publication. Hong Kong Monetary Authority Monthly Statistical Bulletin. Hong Kong. Various Issues. The Government Printing Department. The Industrial Composition of U. Exports and Subsidiary Sales to the Canadian Market.
American Economic Review 62 1 : Hsiao, C. Analysis of Panel Data. Cambridge: Cambridge University Press. Various Is- sues. Washington, D. Jeon, Y. Weltwirtschaftliches Archiv 3 : Kamath, S. Economic Development and Cultural Change 39 1 : Economic Development and Cultural Change 42 2 : Klein, M. W, and E. Rosengren Kobrin, S. From the discussion above, it is clear that policies on international capital transfers are likely to have greatly influenced patterns and trends in Chinese ODI.
Although it is important for completeness that any formal model of Chinese ODI incorporates a policy dimension, lack of transparency in the application of regulations and incentive policies experienced by investors Wong and Chan, makes this a difficult aspect to capture. Deng Xiaoping's South China Tour in was associated with significant domestic market liberalisation.
In response to this, numerous subnational-level authorities allowed enterprises under their supervision to internationalise, especially towards Hong Kong SAR, in order to engage in real estate and stock market speculation Wong and Chan, Therefore, to investigate the role of institutional liberalisation towards ODI, we introduce a time dummy for We control for a number of conventional variables from standard theory to specify correctly the estimated equation, and so to reveal the effects of the main variables, including those to test the special theory applied to Chinese ODI.
A low or undervalued exchange rate encourages exports but discourages outward FDI Kohlhagen, ; Logue and Willet, ; Stevens, As the home country exchange rate appreciates, more profitable opportunities for outward FDI will occur as foreign currency denominated assets become cheaper. It is possible that a rapid appreciation of the exchange rate, from a low or undervalued position, will more than proportionately increase outward FDI. For this reason, the exchange rate is included as a control variable.
Volatile and unpredictable inflation rates in a host country discourage market-seeking FDI by creating uncertainty and by making long-term corporate planning problematic, especially in respect of price-setting and profit expectations. High rates of inflation may also lead to domestic currency devaluation, which in turn reduces the real value of earnings in local currency for market-seeking inward-investing firms. High inflation rates tend to check the export performance of domestic and foreign investors and thereby discourage export-oriented FDI by increasing the prices of locally sourced inputs, making it harder to maintain a cost advantage in third markets.
We therefore expect a negative relationship between Chinese ODI and host country inflation. Exports from China proxy the intensity of trade relations between home and host country by capturing the market-seeking motive of Chinese firms. During the s and early s, much Chinese ODI took place to provide a local support function for domestic Chinese exporters and to help them increase their hard currency earnings Wu and Sia, Typically, such investments were small scale, with local subsidiaries providing information, international trade, transportation and financial services to their Chinese principals and other Chinese firms Ye, ; Zhan, In some cases, these were vanguard operations for later and more substantial investment.
Imports to a home country from a host country also capture the intensity of trade relations. Since they are an indication of the importance of the resources transferred we would expect home country firms to internalise these strategic flows using outward FDI as the key mechanism Buckley and Casson, Internalisation theory predicts that market-seeking firms are more likely to serve geographically proximate countries through exports and more distant markets via FDI Buckley and Casson, This suggests a substitution of FDI for other modes as distance increases.
However, our dependent variable is in the form of the annual flow of Chinese FDI alone i. As we predict the flow of FDI to be greatest to nearby countries, so we would expect to capture a negative effect of distance on the flow of FDI Loungani et al. A physical distance variable is therefore needed to complement our cultural proximity variable, to isolate its effect. We incorporate distance as a control. The more open a country is to international investment, the more attractive it is likely to be as a destination for FDI Chakrabarti, We include openness to FDI in our investigation, as a control:.
Chinese ODI is associated positively with the degree of openness of the host economy to international investment. Our hypotheses, their theoretical justification, the proxies we use and the expected signs are detailed in Table 3 , together with our data sources. We expect the distinctive nature of the factors influencing Chinese ODI to be captured by the collective significance in the main variables that we identify in the table. The data are transformed into natural logarithms as we expect non-linearities in the relationships on the basis of theory and previous empirical work.
Our dependent variable is the total amount of foreign exchange approved by SAFE during the project investment process. This includes pre-approved re-invested earnings and intra-company loans, plus in-kind investment up to the total authorised value of a given project, in addition to equity capital. Two statistical models were used to estimate Eq. A fixed effects FE model cannot be used since Eq. To investigate heterogeneity within the data we employ a structural break framework.
First, we investigate the impact of significant changes in the policy regime dating from These changes might influence the decision-making of investors across all the variables. Therefore we divide the period into two phases: — and — Second, and as our discussion above has indicated, China's preference to invest in developing countries may indicate a different model of investment behaviour arising from state policy.
To investigate this possibility we draw a distinction between developed and developing hosts using their OECD membership status. In preliminary regressions, two of the three alternative measures of host market size growth in GDP and GDP per capita never attained significance and were therefore not included in the final specification, which is reported in Table 6.
The absolute host market size variable is retained to capture the market-seeking motive Hypothesis 1a and to act as a control for market returns in the estimation of the relationship between Chinese ODI and host country risk.
However, the large and significant LM value indicates in favour of the RE and therefore only the results from RE are discussed. Tables 4 and 5 present the correlation matrix and variance inflation factor VIF test results, which indicate that there are no general problems with the data. We first discuss the results of the RE model for the main variables column 2, Table 6. We find that host market characteristics measured by absolute size of economy, LGDP , cultural proximity CP and policy liberalisation TD 92 are all significant and correctly signed.
These findings support Hypotheses 1a, 5 and 6. By contrast, political risk LPOLI is found to be significant but with a sign contrary to expectation as predicted in Hypothesis 4. Therefore Hypotheses 2 and 3 are not supported. We now discuss each of these main findings in more detail. This indicates that market seeking was a key motive for Chinese ODI in the period under study Hypothesis 1a. This result suggests that the presence of ethnic Chinese people in the host country has promoted inward investment by Chinese firms.
The policy liberalisation variable TD 92 is also positive and significant. This supports the argument that the qualitative changes in Chinese policy that took place in , the year of Deng Xiaoping's visit to the southern provinces, did mark a significant step towards liberalisation in a number of ODI-related areas, and positively influenced the value of approved Chinese ODI for that year Hypothesis 6.
Our interpretation is that policy changes freed SOEs to invest abroad for reasons other than the promotion of exports, that is, they were able to service foreign markets directly. A major finding is that the coefficient on the index of political risk LPOLI indicates an increasing relationship between host country political risk levels and Chinese ODI. Thus we find no evidence to support Hypothesis 4.
This runs counter to the normal findings for this variable, and requires discussion. In line with theory advanced in this paper, capital market imperfections and institutional factors in China may have induced a perverse attitude to risk, which contrasts with that found among industrialised country firms. In other words, Chinese foreign investors seem not to perceive risk in the same way as industrialised country firms.
There are a number of reasons why Chinese firms may not behave in the conventional manner. First, Chinese state-owned firms may not be profit-maximisers, or may be maximising subject to government-led institutional influences. Second, the bulk of Chinese FDI is in developing countries see Table 2 , and these are precisely the countries that, as a group, record higher levels of political risk. Much of this investment may have been promoted by political affiliations and connections between China and the developing host country government concerned.
Third, China's political and ideological heritage in the modern era may have led to Chinese ODI being preferentially directed to fellow communist or ideologically similar countries, many of which also record higher levels of political risk. Fourth, home country embeddedness i. Fifth, Chinese firms may also be prepared to invest in countries generally avoided by industrialised country firms for ethical e.
Sixth, we should finally note that the relative inexperience of some Chinese firms concerning the establishment and management of large-scale operations abroad may have led to FDI projects being undertaken with insufficient due diligence and attention to associated risks Wong and Chan, ; Ma and Andrews-Speed, Our finding for risk also highlights potential shortcomings in familiar measures of political risk, which are typically calculated from the point of view of industrialised country firms World Bank, Such indices may need to be recalculated to better capture the perceptions of firms from emerging economies like China.
Given that our regression specification controls for market returns, it does appear that Chinese behaviour towards conventionally measured host political risk differs from that of developed country investors. In line with the theory put forward earlier, the evidence suggests that capital market imperfections play a role. Of the main variables we examine, we find no support for Hypothesis 3. The asset-seeking variable LPATENT in the RE model is insignificant, which suggests that Chinese firms have not been motivated to acquire strategic intellectual capital assets over the period under study.
We now discuss the results for our six control variables. In short, we find no support for Hypotheses 7, 11 or It also supports the market-seeking motive Hypothesis 9. This finding concurs with the view that one of the key motivations of Chinese investment has been to promote domestic exports. This result could be generated by the practice of Chinese investors relocating production from China to other developing countries. In this account, imports of intermediate products to China for processing and re-export are reduced when Chinese firms relocate processing abroad via FDI.
By value, most Chinese ODI is in the developing countries see Table 2 , and outward investment to these countries to circumvent trade barriers in third markets may have been a motive. This is contrary to expectation Hypothesis 8. Such an association might suggest that countries with moderate demand inflation are more attractive to Chinese investors. This link between the variables would be reasonable on the assumption that moderate demand inflation accompanies economic growth.
It may also support the view that the investment decisions of Chinese firms are unusually tolerant of less stable countries with respect to local economic conditions. This contrasts with the normal behaviour of profit-maximising industrialised country firms, and again suggests that Chinese firms may be influenced strongly by home country capital market failure and institutional factors. In order to investigate whether or not Chinese FDI has changed in character over the period in question, we divide our data into two time periods around This procedure is borne out by the results in columns 3 and 4 of Table 6 , which contrast sharply.
These indicate that different locational determinants and motivations apply over time. We also detect differences across time among the control variables. These findings are in agreement with the earlier discussion that there has been a significant change in the foreign investment behaviour of Chinese enterprises over time, and that this is at least partly due to the variable policy regime, as suggested by our finding for the policy liberalisation variable TD 92 , which indicates a surge in ODI for the year Arguably, this provides further substantiation for the notion that institutional factors have influenced patterns of Chinese ODI.
We find that, over the period under study, Chinese firms have moved away from undertaking mainly market-seeking strategies in nearby foreign markets towards the securing of raw materials in riskier markets. These findings reinforce the view that the securement of natural resources has become an imperative in more recent years, in line with Chinese domestic growth, and that this investment has been directed to countries with higher levels of political risk by Western standards. The fact that LDIS is significant and negative for the earlier period but not for the later one shows that geographic proximity of host countries to China was a positive influence only on early Chinese ODI.
This development may be an outcome of the growing maturity of Chinese market-seeking investors and the increasing propensity for Chinese firms to engage in natural resources in more spatially distant markets. The highly significant and positive coefficient for cultural proximity CP in both time periods columns 3 and 4 supports our hypothesis that familiarity between populations is important in the flow of Chinese FDI. The facilitating role of the Chinese diaspora persists throughout the period under study, as expected, and suggests that relational assets indeed constitute an ownership advantage for Chinese firms when they invest in countries with a significant Chinese population.
In the later period only, ODI is positively associated with Chinese exports, indicating that a significant part of FDI has followed export trade. Theory suggests that home country market imperfections can exert a significant impact on the decisions of foreign investors.
It follows that Chinese government policy may have led to a distinctive pattern of outward FDI by host country. Here, we test this for developed and developing countries by comparing results for the subsamples of OECD and non-OECD countries in columns 5 and 6 of Table 6 , respectively. This is a conventional result, and captures that part of Chinese FDI that is market seeking. Also significant is the cultural proximity variable CP. This variable appears to be capturing the tendency for Chinese firms to invest in OECD countries where a sizeable population of ethnic Chinese can be found.
The highly significant and positive policy liberalisation variable for OECD countries alone TD 92 in column 5 of Table 6 again yields insight into the relatively undeveloped state of the FDI decision process by Chinese investors. The policy change in is associated with a large increase in FDI to the developed world. This implies that the decision to invest was previously tightly circumscribed by government, and this may be the reason why a full and conventional pattern of significance is not observed.
However, the pattern of investment flows to the developed economies fits with Chinese government priorities during liberalisation. This suggests that Chinese ODI follows trade for both categories of country. These results indicate that it is specifically those developing countries from which China imports least to which Chinese investors have been attracted. This suggests that moderate inflation is a characteristic of those buoyant markets that attracted Chinese firms.
One of the most compelling earlier findings — that our main variable political risk LPOLI is significant — is lost in both estimations 5 and 6. From this, we infer that, while Chinese ODI is associated with higher levels of host country political risk, the difference in risk in the data is primarily that between developed and developing countries, rather than within these two country groupings.
The apparent preference for less developed and risky host countries as against developed hosts is consistent with our argument on the lower cost of capital enjoyed by SOEs, as well as with the relatively unsophisticated country risk evaluation processes of Chinese investors. This result supports our theoretical contention that capital market imperfections in China have been crucial to outward FDI over the period in question. This paper is one of the first attempts to formally model Chinese ODI.
Our motivation is to test the extent to which the mainstream theory that explains industrialised country FDI is applicable to emerging country contexts, and whether special explanations nested within the general theory are needed. We develop a theoretical framework that draws on this body of theory but which allows for both conventional and novel hypotheses to be tested. This is done within a well-specified model using previously unexamined official data on Chinese ODI and by employing a wide range of main and control variables.
We find that Chinese ODI has both a conventional and an idiosyncratic dimension. In terms of our main variables, we find a conventional result for market size. We infer from the significant role played by host country natural resource endowments that the institutional environment has strongly shaped Chinese ODI, leading to significant natural resources-seeking FDI. We also find that policy liberalisation has had a positive influence in stimulating Chinese ODI.
Viewed together, these findings are in agreement with the well-publicised expansion of natural resources-seeking activities of Chinese MNEs in recent years, especially to the industrialised countries, in response primarily to domestic economic imperatives Taylor, ; Deng, , Although there are indications that Chinese firms have become increasingly acquisitive in recent years, we find that, prior to when our data end , ODI was not driven by the motive to acquire strategic assets.
Cultural proximity is found to be a significant factor, indicating that reduced transaction costs and network effects are important in attracting Chinese investors, and that relational assets constitute a special ownership advantage, even for state-owned firms. This supports a role for reduced psychic distance in explaining Chinese ODI.
When we examine differences over time, we find that market size, geographic proximity, inflation and market openness are important locational determinants for the period to , with the distance variable suggesting that the Chinese diaspora and market familiarity have positively influenced the destination of earlier Chinese investment outflows. However, the finding that the cultural proximity variable does not change over time suggests that Chinese ODI is still in an early stage of development, and that more familiar cultures in host countries continue to help promote Chinese inward investment.
These findings warrant further investigation on a longer time series of data. More challenging is the unprecedented finding that Chinese ODI is attracted, rather than deterred, by political risk as measured conventionally and with market returns controlled for by market size.
This suggests that Chinese firms do not perceive or behave towards risk in the same way as do industrialised country firms. In accordance with our theory, we attribute this to the low cost of capital that Chinese firms for the most part SOEs enjoy as a consequence of home country capital market imperfections. Indeed, state ownership can be considered as a firm-specific advantage for many Chinese MNEs in this context Ding, However, the experience of operating in a highly regulated and controlled domestic environment i.
This experience may have equipped Chinese MNEs with the special ownership advantages needed to be competitive in other emerging economies. Moreover, further augmentation of the ownership advantages of Chinese firms is likely to occur as Chinese MNEs become more experienced internationally Deng, and as the Chinese government and its agencies continue to provide political, financial and other support, as implied by our discussion of institution-based theory.
Chinese firms that invest abroad have to straddle environments, institutions and rules that differ probably more than for any other outward-investing country in the world. In this paper we have expected contrasts with the conventional model, and we have found evidence for these. Theorising on the strategy of firms, especially those from emerging countries, needs to pay greater attention to the influence of home country institutions.
It is arguable that Chinese firms seek foreign investment opportunities in environments that resemble their home environment. Further, it is tenable that Chinese investors are unconstrained by the ethical and governance obligations that are normally expected of Western MNEs today.
For the present, Chinese outward investors clearly present marked contrasts from the conventional model in key respects. First, state direction over firms whether formal or informal is likely to generate a signature in the locational pattern of outward investment that would not be predicted by the general theory of FDI, which assumes that firms are profit maximisers.
The second implication is that liberalisation is a very powerful instrument for emerging economies. This does not simply mean trade liberalisation, but includes the whole range of internal liberalisations possible for countries with a significant state sector or dominant private or public firms, or both. The behaviour of domestic firms changes dramatically once competition, or its prospect, is introduced. Firms that performed a social role, such as the SOEs, once divested of this, are able to seek growth.
However, China remains distinctive from other emerging economies in that many of its MNEs remain in state hands, even though corporatised in order to focus on commercial objectives. State direction means that these firms still align their operations, whether at home or abroad, with the five-year plans and national imperatives. This is a model that is not replicated, in any general way, in any of the other leading emerging economies. With respect to further work, an issue requiring investigation, possibly of a qualitative nature, is whether or not and how Chinese investors are influenced as are industrialised country firms by concerns of due diligence, risk evaluation and ethical considerations in host countries.
Similarly, how patterns of FDI are affected by formal and informal political links between China and other countries i. FDI normally has three components: 1 equity capital the purchase of shares in the foreign enterprise ; 2 reinvested earnings those earnings not distributed as dividends by foreign affiliates or remitted to the investor enterprise ; and 3 intra-company loans or debt transactions borrowing and lending between parent and foreign affiliate enterprises UNCTAD, a.
The Republic of China Taiwan is treated as a separate economy. Regions with disputed borders e. Overseas Chinese are defined by Poston et al. This also reflects the regulatory framework of Chinese ODI over the majority of the period under study. Until quite recently, Chinese firms were obliged to repatriate overseas earnings to financial authorities at home, while the ability to make inter-company loans was highly restricted under China's foreign exchange controls.
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