Does foreign direct investment crowd in or crowd out private domestic investment in China? The effect of entry mode

Highlights

• This paper emphasizes the effect of entry mode on domestic investment in China.

• The ARDL bounds test to cointegration is applied to the period 1994Q1–2014Q4.

• A neutral FDI–domestic investment nexus during the sample period.

• EJV crowds in domestic investment, but WFFE crowds it out during the sample period.

• EJV needs to be encouraged as the launch pad for industrial upgrading in China.

Abstract

Using quarterly data spanning from 1994Q1 to 2014Q4, we find a neutral relationship between foreign direct investment (FDI) and domestic investment in China. However, when we consider the entry mode chosen by foreign investors, we find that whilst equity joint venture (EJV) crowds in domestic investment, wholly foreign-funded enterprise (WFFE) crowds it out. Our results remain robust under alternative estimators and across different time periods. Based on these results, we argue that the Chinese government needs to actively promote the formation of EJV and uses it as the catalyst for industrial upgrading in the economy.

Introduction

Following the famous 1992 Southern Tour by then the Chinese leader, Deng Xiaoping, foreign direct investment (FDI) in China enjoyed, for the most part of the last two decades, unprecedented growth. Driven by the renewed interest following its accession to the World Trade Organisation (WTO) in 2001, China surpassed the United States as the world's most popular destination among international investors for the very first time in 2003. To put this achievement into perspective, UNCTAD (2015) reported that in 2013 China hosted approximately US$1,085 billion or around 13% of the total FDI stock in the developing world. With this backdrop, many researchers argue that FDI plays a catalytic role in modernizing the Chinese economy, not only in terms of promoting technological transfers, but also in transforming business practices and the institutional environment in China (Berthélemy and Démurger, 2000, Cole et al., 2009, Elliott et al., 2013, Havrylchyk and Poncet, 2007, Hering and Poncet, 2010, Lo et al., 2016, Long et al., 2015, Madariaga and Poncet, 2007, Whalley and Xin, 2010, Yang et al., 2013). Undoubtedly, these positive spillovers further reinforce the willingness of the Chinese firms to re-invest, contributing to China's impressive growth record since the early 1990s. For example, Sun (1998) attributes at least one third of the growth in domestic private investment (henceforth, domestic investment) in 10 coastal provinces during the 1983–1995 period to the influx of FDI. Meanwhile, Xu and Wang (2007) examine China's national accounts data and find that FDI crowds in domestic investment from 1980 to 1999. Tang et al. (2008) extend this idea to show unidirectional causality running from FDI to domestic investment in China over the 1988–2003 period.

However, not everyone shares such an optimistic sentiment and argues that FDI crowds out domestic investment, damaging the long-term prosperity of the host country. In part, this pessimistic view stems from the premise that FDI intensifies competition in local factor and product markets that either reduces the willingness of the indigenous firms to re-invest or drives the incompetent ones out of business altogether (Aitken and Harrison, 1999). Meanwhile, Gall et al. (2014) show that a sudden withdrawal of FDI may severely hinder the growth prospect in those host countries with imperfect credit markets. Indeed, as witnessed during the 1997 Asian currency crisis, and more recently, the global financial crisis in 2008, an unexpected decline in FDI presented a major obstacle impeding the recovery process in many emerging economies. This crowding-out hypothesis echoes Huang, 2003a, Huang, 2003b argument that China's massive influx of FDI merely reflects institutional deficiency brought about by inefficient allocation of resources under a planned economy. Specifically, he suggests that preferential treatment given to state-owned enterprises by China's state-led banking sector has significantly limited the scope of growth in many private firms. In order to overcome this lack of credit availability and other finance constraints, many rapidly growing private firms start to seek foreign partners (Egger and Nelson, 2011). In this regard, FDI simply substitutes domestic investment, leaving little changes to the level of overall investment in China. This substitution hypothesis is supported by Braunstein and Epstein (2002), who examine the FDI–domestic investment nexus in 29 Chinese provinces during the 1986–1999 period and question the widely held belief that China's rapid ascendancy was largely propelled by FDI.

Despite a rather voluminous literature on the causes and effects of FDI in China, most studies have ignored the effect of entry mode on the relationship between FDI and domestic investment in the Chinese economy. According to China's National Bureau of Statistics (NBS), the top-three entry modes chosen by foreign investors are equity joint venture (EJV), contractual joint venture (CJV), and wholly foreign-funded enterprise (WFFE).¹ A recent study by Ashraf and Herzer (2014), who investigate the effect of entry mode on the FDI–domestic investment nexus in 100 developing countries, conclude that whilst there is a neutral relationship between merges and acquisitions (M&As) and domestic investment, WFFE tends to crowd out domestic investment. If their finding also holds true for China, then the policy makers need to curtail the growth of WFFE, which has been that most preferred entry mode in China since 1999, particularly among investors from Hong Kong, Macao, and Taiwan.

Our study represents the first systematic inquiry into the fundamental relationship between entry mode and domestic investment in China. Conceptually, we extend Ashraf and Herzer (2014) by also including EJV and CJV, two of the most popular entry mode chosen by foreign investors in China, in the analysis. Methodologically, our study examines the association between entry mode and domestic investment through the lens of the autoregressive distributed lag (ARDL) bounds test. According to Pesaran et al. (2001) and Narayan and Smyth (2005), this test delivers much better small sample properties and places less restrictive conditions on the order of integration in the model. Apart from the conceptual and methodological considerations, our analysis focuses on quarterly data spanning from 1994 to 2014, which takes into the account the impact of China's accession to the WTO in 2001 on the entry mode–domestic investment nexus.

In general, we find a neutral relationship between FDI and domestic investment in China for the entire sample period. However, when we introduce entry mode into the analysis, we find that EJV crowds in domestic investment, but WFFE crowds it out. Furthermore, we show that the nature of the FDI–domestic investment nexus changes over time. Specifically, we find that whilst FDI crowds in domestic investment prior to joining the WTO, FDI crowds it out during the post-WTO era. Based on these findings, we argue that the Chinese government should encourage the formation of EJV and uses it as the platform for encouraging industrial upgrading in the economy.

The remaining part of this paper is structured as follows. Section 2 provides a brief literature review on the current state of research on the FDI–domestic investment nexus. Section 3 describes the emerging trend of entry mode in China and argues for its inclusion in the analysis. The econometric framework and results are discussed in 4 Econometric framework, 5 Results, respectively. Section 6 concludes.