The inflow of foreign direct investment to China: the impact of country-specific factors

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1 Journal of Business Research 56 (2003) The inflow of foreign direct investment to China: the impact of country-specific factors Yigang Pan* York University, Toronto, Ontario, Canada The University of Hong Kong, Pokfulam Road, Hong Kong, China Abstract This study examines the impacts of source and host country factors on the inflow of foreign direct investment (FDI) into China between 1984 and Drawing upon the existing FDI literature, some findings related to Western countries are investigated for China. In addition, effects that are particularly salient to transitional economies, such as risk conditions in the host country, are hypothesized and tested. D 2003 Elsevier Science Inc. All rights reserved. Keywords: Foreign investment; Country-specific factors; Transitional economies; China 1. Introduction Research on foreign direct investment (FDI) has attracted the attention of scholars in the fields of international business and economics over the last decade. In particular, there is a sizeable body of knowledge regarding the inflow of FDI into the United States (Grosse and Trevino, 1996; Tallman, 1988). By comparison, less is understood about what drives FDI in transitional economies, such as China (Batra, 1997; Child and Tse, 2001). China is the second largest recipient of FDI in the world. FDI in China increased from less than US$10 billion in 1990 to US$42.6 billion in 1996 (Chadee and Qiu, 2001). By the end of 1996, Chinese authorities had approved 284,000 foreign enterprises, 140,000 of which had begun operation (China statistical yearbook, 1997). Foreign enterprises are estimated to employ more than 17.5 million people (about 10% of the country s nonrural labor force) and account for nearly half of China s total foreign trade volume. In short, FDI in China plays a pivotal role in the country s economy. Nonetheless, our understanding of the drivers of foreign investment in China is much weaker than our understanding for the developed world. * The University of Hong Kong, Pokfulam Road, Hong Kong, China. Tel.: ; fax: address: ypan@hkusua.hku.hk (Y. Pan). The goal of this study is to investigate the influence of several country-specific factors on the inflow of FDI in China. Drawing on existing literature, I propose that factors related to both the source country and the host country can be used to explain the inflow of FDI in China. Data on FDI into China from 30 countries, between 1984 and 1996, are used to investigate this issue. 2. Theoretical development and hypotheses Country-specific factors are macro-level environmental characteristics of the source and host countries that are presumed to affect firms investment activities (Kogut and Singh, 1988; Tallman, 1988). The factors addressed in this study reflect economic, political, and cultural considerations Exchange rate Previous research has shown relationships between exchange rate fluctuation and FDI. Examining the movement of FDI into the United States, Froot and Stein (1991) found dollar depreciation to be associated with additional FDI inflows during Pan (2002) noted that firms from countries with appreciating currencies tend to acquire higher equity levels in joint ventures in China. Caves (1988) also found that the strength of a /03/$ see front matter D 2003 Elsevier Science Inc. All rights reserved. doi: /s (02)

2 830 Y. Pan / Journal of Business Research 56 (2003) country s currency, relative to the dollar, is an important explanatory variable for its direct investment in the United States. Conceptually, exchange rate fluctuations affect FDI in two ways (Dewenter, 1995). First, the appreciation of a source country s currency against that of a host country means that the source country s investment increases in value when denominated into the host country s currency. This makes the investment cheaper from the source country s perspective (Ajami and Barniv, 1984; Cushman, 1985; Grosse and Trevino, 1996). Froot and Stein (1991) argued that currency appreciation increases the wealth position of firms denominated in foreign currencies, lowering their relative cost of capital and allowing them to invest more aggressively overseas [A case in point is the massive Japanese overseas investment in the late 1980s.]. Second, currency appreciation makes goods from the source country more expensive when denominated in the host country s currency, making exporting from the source country to the host country less cost-competitive. This motivates firms from the source country to relocate the production of goods to the host country (Froot and Stein, 1991). Both considerations mean that a currency appreciation in the source country should be associated with higher outward direct investment from firms in that country. Therefore, I H1: Source countries with an appreciating currency have a higher level of FDI in China Cost of borrowing Previous studies have shown that the cost of raising capital in a country affects its FDI outflow (e.g., Froot and Stein, 1991; Pan, 2002). Higher lending rates increase such costs, causing firms to earn higher profits to meet their expectations net of debt repayments. Domestically, it can be argued that firms compete on roughly equal footing, because they are faced with similar interest rates. Internationally, however, firms from source countries with high lending rates are at a cost disadvantage in raising capital, compared with those from countries with low lending rates (Grosse and Trevino, 1996). One might expect that, in a world with mobile capital, risk-adjusted expected returns on all international assets would be equalized, meaning that interest rate differences should have no bearing on FDI. In reality, capital mobility is not perfect. Only very large multinational corporations can raise capital internationally. In addition, complications such as hidden costs and exchange rate fluctuations work against raising capital in a third country. Grosse and Trevino (1996) found that the cost of borrowing at home did affect outward FDI into the United States. Firms from countries with low interest rates enjoy a cost advantage that enables them to raise more capital with a lower burden of interest payment. Holding other factors constant, such firms should be able to raise more capital for overseas investment. Thus, I expect: H2: Source countries with lower lending rates have a higher level of FDI in China Size of source country The existing literature suggests source country size has a positive impact on the outflow of FDI (Ajami and Barniv, 1984; Tallman, 1988; Grosse and Trevino, 1996). It is easier for firms from a large home country to raise the capital needed to invest overseas. Because larger countries tend to have more firms that can expand into international markets aggressively and on a larger scale, I hypothesize the following: H3: Source countries with higher GDP have a higher level of FDI in China Reliance of source country on external trade A country s ability to engage in external trade is expected to affect its ability to undertake FDI (Ajami and Barniv, 1984; Grosse and Trevino, 1996). Firms in countries with a heavy reliance on external trade are more accustomed to learning and operating in a foreign environment. They know more about how to compete on the world market, and should be more likely to invest in a foreign host country. In addition to overall world trade positions, the level of bilateral trade between the source and the host countries is of interest. Following the same logic, I expect that the higher the volume of bilateral trade, the higher the volume of FDI from the source country to the host country. Thus, I H4: Source countries with higher volumes of external trade and bilateral trade with China have higher levels of FDI in China Risk conditions in host country Past studies have proposed that, when a host country is riskier, foreign firms are less likely to invest nonredeployable assets there (Erramilli and Rao, 1993; Kim and Hwang, 1992). However, Pan (1996) found the reverse, considering the risk situation and foreign equity ownership in China. Foreign firms investing during riskier times may place importance on acquiring a higher level of equity, in order to have control of the venture. This is particularly salient in a transitional economy like China. When the broad-based country risk deteriorates, state-owned local firms tend to be mired in trouble, forcing foreign firms to take control if they want to invest in China at all (Pan and Li, 2000). Nonetheless, because previous studies on the macro-level inflow of FDI point to the pattern that it is affected negatively

3 Y. Pan / Journal of Business Research 56 (2003) by deteriorating risk conditions in the host country (Grosse and Trevino, 1996), I hypothesize as follows: H5: The level of FDI into China increases as the risk conditions in China improve Closeness between source and host countries The attractiveness of a host country differs in the eyes of firms from different nations. Previous studies have indicated that firms prefer to invest in countries that are culturally similar to their own (Kogut and Singh, 1988). If they are culturally close to a host country, investing firms are likely to have better knowledge of the local market, customers, and business networks. Two indicators have been used to assess the closeness between two countries. One is the length of diplomatic ties (Tse et al., 1997). Studies suggest that countries with longer diplomatic relationships tend to be closer economically. An existing diplomatic relationship offers businesses formal channels of communication, exchange, and protection. The longer the diplomatic relationship, the longer the history of exchange between firms in the two countries. Thus, I expect that the inflow of FDI into China will be higher from source countries with longer diplomatic ties with China. The second measure is the geographic distance between two countries. Larger geographic distance is presumed to make conducting business more inconvenient. Thus, I H6: The level of FDI into China increases as the length of diplomatic ties increases and the geographic distance decreases between China and the source country Management orientation of host country The attractiveness of a host country also depends on its similarities to the source country, in terms of business practices. Large differences make it harder for investors to acquire information and to monitor, evaluate, and control their overseas operations (Kogut and Singh, 1988). One important managerial distinction between countries is due to risk orientation, or uncertainty avoidance (Hofstede, 1994). This is the extent to which people of a culture feel threatened by uncertain situations. In low uncertainty avoidance countries, firms tend to be more risk taking and less worried about a lack of predictability. Such firms are likely to be more willing to engage in FDI, compared to firms from source countries with high uncertainty avoidance. Another cultural difference relates to power distance (Hofstede, 1994), which is the extent to which the less powerful members of institutions within a culture accept that power is distributed unequally. Small power distance means that people in a society see themselves as relatively equal to others. Large power distance implies that people accept more unequal relationships among individuals, in terms of social and business hierarchies. Firms from source countries characterized by large power distance may prefer to maintain hierarchical relationships in their overseas investments, making them more likely to pursue FDI, rather than other, more cooperative types of ventures. Thus, I H7: The level of FDI into China is higher from source countries with low uncertainty avoidance and with high power distance. 3. Method 3.1. Dependent variable The dependent variable is the annual FDI inflow into China from each of 30 countries between 1984 and 1996, from the Almanac of Foreign Economic Relations and Trade of China ( ). The data represent utilized, as opposed to contracted, FDI Independent variables Data for several of the independent variables are sourced from the International Financial Statistics ( ), published by the International Monetary Fund ( ). Exchange rates are measured by the ratio of RMB to the currency of each source country, in US dollars, for each year. Lending rates are used to reflect the cost of borrowing and GDP represents size. Reliance on external trade is measured by each country s volumes of import and export. Bilateral trade between the source country and China is obtained from the Almanac of Foreign Economic Relations and Trade of China ( ). Risk conditions in China are measured in two ways. The first is an annual risk assessment reported by Euromoney ( ); this is on a scale of 0 100, with 100 indicating a risk-free environment. The second measure is a dummy variable to capture the impact of 1989 Tiananmen Square incident, coded as 1 for 1989 and 1990, and 0 for other years. The length of diplomatic ties is operationalized as the number of years since the source country established diplomatic relationships with China. Geographic distance is measured using a categorical variable, with a larger number indicating farther distance from China; Hong Kong = 1, South East Asia = 2, Japan and South Korea = 3, US and Canada = 4, and Europe = 5. The data for uncertainty avoidance and power distance are from Hofstede (1994). 4. Results Table 1 reports the annual inflows of FDI to China from six major sources: Hong Kong, Japan, US, Germany, UK,

4 832 Y. Pan / Journal of Business Research 56 (2003) Table 1 Annual inflow of foreign direct investment in China (in million US dollars) Year Hong Kong Japan USA Germany UK France , , , , , Data source is the Almanac of Foreign Economic Relations and Trade of China ( ). and France. Hong Kong is the largest investor, with levels of over US$20 billion in 1995 and The pattern of FDI inflow reflects changes in the Chinese investment environment. As the legal framework, market systems, and infrastructures are improving in China, the volume of FDI has tended to increase. However, 1989 saw a dramatic downturn in FDI inflow. Interestingly, FDI from Hong Kong and Japan was reduced dramatically after the 1989 Tiananmen incident, while investment from the US, Germany, and Britain was less immediately affected. The high investments of Hong Kong, Japan, Germany, and the US in 1991 probably pent-up demand from firms on hold after the Tiananmen incident Regression results Two regressions were run (Models I and II) to allow for a more complete assessment of the hypotheses (see Table 2) Exchange rate Exchange rate is not found to be a significant determinant for aggregate FDI inflow in China in either Model I or Model II. Thus, H1 is not supported [It is interesting to note the changes in the Chinese currency over the period of this study. The RMB was devalued gradually from 1.5 per U.S. dollar in the early 1980s to 3.8 in It dropped to 4.8 in 1990, and to around 5.5 during In 1994, it nosedived to 8.6, and has since been hovering at around that level.] Cost of borrowing The cost of borrowing in the source country has a negative association with its inflow of FDI to China, supporting H2. In line with the existing literature, firms from source countries with lower lending rates are more likely to invest in China Size of source country Source country GDP has a significant impact on FDI in China, but a negative one. Contradicting H3, this result indicates that the smaller the size of source country, the more FDI in China it tends to have. It is possible that smaller countries are more eager to explore the newly opened transitional economy. It is also possible that this finding was driven by the heavy investments from Hong Kong and Singapore Reliance on external trade Supporting H4, higher levels of both external trade in source countries and bilateral trade with China are associated with higher inflows of FDI into China Risk condition of China The support for H5 is mixed. The coefficient for the Tiananmen Square incident dummy variable was negative and significant, indicating that 1989 and 1990 saw a decline in FDI inflow. However, the Euromoney ( ) risk variable revealed counter-intuitive results, showing that more favorable risk assessments were associated with smaller inflows of FDI [The risk assessments by Institutional Investor yielded similar results.] Closeness to host country Neither the length of diplomatic ties nor geographic distance plays a significant role in predicting the inflow of FDI into China, so H6 receives no support Managerial orientation Both the risk avoidance and power distance portions of H7 are supported. The results indicate that firms from high risk avoidance countries have lower FDI in China, while those from high power distance countries have higher FDI. Table 2 Determinants of foreign direct investment in China Independent variables Model I Model II Intercept (0.775)* * * (1.677) Exchange rate (0.078) (0.065) Lending rate (0.039)* * * (0.030) Uncertainty avoidance (0.008)* * * (0.008) Power distance (0.009)* * * (0.009) Source Country GDP (0.000)* * * Source Country Trade (0.001)* * * Country risk (China) (0.014)* * * 1989 Tiananmen incident (0.326) * * Bilateral trade volume (0.019)* * * Bilateral diplomatic tie (0.015) Geographic distance (0.231) Model R N The numbers in parentheses are standard errors. ** P <.05. *** P <.01.

5 Y. Pan / Journal of Business Research 56 (2003) Discussion Source country characteristics can be seen as push factors for overseas investment. Such factors have been well documented in previous research on macro-level flows of FDI. However, existing studies are largely based on data from developed countries. In this study, I have verified some earlier findings in the transitional economy of China. Not all of the hypothesized relationships (e.g., exchange rates and source country size) were supported, implying that some of the FDI patterns observed in developed countries cannot be generalized to transitional economies. Based on the empirical evidence, it is possible to speculate on the motivations of foreign firms investing in China. It is likely that a substantial proportion of the FDI in China has been aimed at tapping China s domestic market. Under this assumption, we can understand why some factors did not play their expected roles. Exchange rates may not be important considerations because foreign firms are not planning to take profits out of China in the short term. When investing in developed countries, firms tend to plan for capital movements into and out of the host country. In this transitional economy, foreign investment may be for a longer duration, reducing the importance of exchange rates as a consideration. Even though Pan (2002) found that foreign firms from a source country with an appreciating currency hold more equity ownership in joint ventures in China, this study does not find that the appreciating currency is associated with a larger amount of FDI in China. Evidently, foreign investment in joint ventures is only part of the aggregate FDI. In other words, future research should explore the relationship between exchange rate of a source country and its overseas investment using different modes of entry. Similarly, proximity to the host country may be more important for firms engaging in sourcing activities, instead of market seeking activities. When aiming at penetrating the Chinese market, firms from more distant source countries may have more incentive to establish the investment in China, reducing transportation costs. There are limitations in this study that should be addressed in future research. The study is based on archival data. While the size of the archival data set and its longitudinal nature are strong points, it lacks the richness to study firm-level decision processes. Another limitation is the lack of some measures (e.g., relative rate of return) used in previous studies, preventing the full replication of studies related to FDI in developed countries. This study shows that FDI in China bears some similarities to FDI in developed countries. More importantly, there are some dissimilarities, which may reveal unique characteristics of FDI in transitional economies. 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