The impact of FDI on trade: evidence from China's bilateral trade

Journal of the Academy of Business and Economics, Jan, 2003 by Yong Li

ABSTRACT

Within a gravity model framework, this paper investigates the impact of foreign direct investment (FDI) on the trade performance of China using trade and stock data on a bilateral basis between China and 75 partner countries/regions over the period 1989 to 2000. It has been found that outward FDI has a larger predicted impact on China's exports than does inward FDI. On the other hand, inward FDI is found having a larger predicted impact on China's imports than does outward FDI. The results from regional breakdown analysis show that the extent to which FDI is trade-enhancing appears to depend on FDI's motivation and region-specific characteristics.

1. INTRODUCTION

Studies (such as Lardy 1996, Zhang, et al. 1999, Liu et al. 2001) have shown that foreign-invested firms have contributed significantly to China impressive export expansion and economic growth. Using panel data at the provincial level in the period of 1986-97, Tse (1997) proved inward FDI positively affect provincial manufacturing export performance. But Sun (2001) argued the role of FDI changes across the regions in China. Although FDI shows a positive and significant impact on exports from coastal region to the central region, its impact on the western region is found to be insignificant. Earlier literature has mainly focused on the impact of inward investment on china's export, while the linkage between inward FDI and exports is quite well understand, there is still a paucity of systematic study on the impact of FDI on China's foreign trade. What is the role of FDI in China's trade expansion, and what is the impact of FDI on China's bilateral trade with its trade partner? Investigation of the linkage between FDI and trade growth would help us to reveal the major motives for investing in Chinese economy and Chinese firm investing abroad, which in turn might allow Chinese policy makers to take appropriate measures for stimulating further capital inflows and outflows. If a negative parameter on inward FDI is obtained in export (import) equation, FDI is considered displacing trade. China's Exports are partially replaced by multinational enterprises (MNEs)' local sales on domestic market, detrimental to the domestic industry's development. Reciprocally, home country's trade balance would benefit from this substitution effect, especially additional imports from the parent company are induced. Trade and outward FDI are complements if a positive parameter is obtained in export (import) equation. Investing abroad leads to an increase in exports (imports) of China towards (from) the host country. Accordingly, an impact on China's trade balance should be positive or negative depending on whether exports increase by more than imports or not.

My work improves upon former studies in three aspects. First, it relates to a set of countries, the contribution made by this paper is in more fully evaluating an important policy question regarding the effect of FDI. For example, it is broader in statistical terms than most other studies by using a panel data set covering 75 countries and 12 years (1989-2000). Second, it takes into account national changes both in inward FDI and outward FDI over a considerable period of time. Third, it is also explicitly based on the idea that the gravity model is a transactions cost model but that regional breakdowns are necessary to incorporate the different motivations for FDI.

The major empirical conclusions of this paper are: (1) Much of the measured trade effect is through FDI rather than cost, as the theory of FDI would indicate, and that studies which concentrate on cost as the channel significantly understate the extent of such expansion. (2) On the whole bilateral country level, outward FDI has a larger predicted impact on China's exports than does inward FDI. On the other hand, inward FDI is found having a larger predicted impact on China's imports than does outward FDI. (3) There is much cross-regional variation and differences in the patterns of FDI-trade links. Regarding to the impact of inward FDI on Chinese trade, FDI is found to boost both export and import growth in Asia, Europe and Oceania. As far as outward FDI is concerned, a unanimous complement link between FDI and trade exists only for Asia, and Africa.

2. THE MODEL

This study examines the linkage between trade and FDI at an aggregate level using bilateral country data. I utilize the gravity model, which has been used to explain bilateral trade flows among many countries over long periods (Frankel et al. 1995; Hejazi and Trefler 1996; Fontagne L. and Pajot M. 2000). In fact, many factors may affect trade flows to and from each country. Trade between two countries should be positively related to their incomes. It can be justified by the modern theory of trade under imperfect competition. Furthermore, GDP per capita has a positive effect on trade: as countries become more developed, they tend to be specialized and trade more. Countries near to China geographically and those with similar languages (cultural similarity) should have lower transactions costs and correspondingly larger levels of bilateral trade. The larger difference in economic stage between investing and recipient countries should have a positive role on trade (Boiling and Somwaru 1999). Obviously, cheap labor or undeveloped internal market in China may attract more investors from developed countries but cannot attract those from the Africa or Latin America since investors from the transition countries have the same conditions in their own countries. Increases in the value of RMB are expected to increases China imports but reduce exports. During the period under study (1989-2000), the Chinese currency has depreciated significantly, and only in recent years (1995 to 1999) did the foreign exchange rate of the currency appreciated slightly. Therefore, foreign exchange rates EX are expected to play a positive role in stimulating exports from China and have a restrain effect on its import. Therefore, the gravity models are modeled as a function of GDP, GDP per capita (PGDP), Economic distance (EDIS), language (LANGU), exchange rate (EX), and outward and inward FDI. To measure the elasticity of changes in trades with regard to percentage changes in the independent variables, the logarithmic form of these variables is used. Let t denote years, c is China, and i is the trading partner country, the transactions cost function is expressed as follows: