Does China receive more regional FDI than gravity would suggest?

European Management Journal (2009) 27, 327– 335

journal homepage: www.elsevier.com/locate/emj

Does China receive more regional FDI than gravity would suggest? Walid Hejazi

*

University of Toronto, Rotman School of Management, 105 St. George St., Toronto, Ontario, Canada M5S 3E6

KEYWORDS China; FDI; Regional versus global; Gravity model

It is an empirical regularity that the activities of multinational corporations are concentrated in their home region. This has been shown to be the case for a majority of the 500 largest multinationals as well as for subsets of this 500 sorted by region or industry. The analysis has also been applied to the activities of a sample of all US and OECD multinationals, aggregated by country. These concentrations have been explained using theories, such as region-bound FSAs which constrain the ability of multinationals to internationalize, as well as transactions costs which make doing business outside a multinationalÕs home market more costly. To date, there has been no analysis that focuses on the regional and global character of multinational activity destined for China. This paper works to fill that void. Using data on FDI into China from each investor country over the period 1995–2005, this paper documents a significant regional concentration of Asian multinational activity operating within China. This regional concentration is sustained even after the special relationships with Hong Kong and (other) Offshore Financial Centres are accounted for. The evidence therefore extends the evidence of regional concentrations of MNE activities found elsewhere to China and its relationship with Asia. ª 2009 Elsevier Ltd. All rights reserved.

Summary

Introduction It can now be considered an empirical regularity that the activities of multinational enterprises are regionally concentrated (Rugman, 2005; Rugman and Verbek, 2008, 2005, 2004; Rugman and Moore, 2003; Rugman and Girod, 2003; Rugman and Collinson, 2007; Rugman and Brain, 2003; Rugman, 2000). Much of this work is based on the analysis of the worldÕs largest 500 MNEs, and use theories * Tel.: +1 416 946 7042. E-mail address: [email protected]

which, for example, demonstrate that region-bound FSAs may constrain the ability of MNEs to internationalize. As a result firms concentrate their activities in the local region. Given the constraint imposed by region-bound FSAs, regional concentrations of MNE activities can still be consistent with profit maximizing behavior. A complementary stream of research has applied a transactions cost approach, namely the gravity model, to explaining these regional concentrations (Hejazi, 2007a,b, 2005). Specifically, this approach would argue that higher costs associated with doing business in distant and foreign

0263-2373/$ - see front matter ª 2009 Elsevier Ltd. All rights reserved. doi:10.1016/j.emj.2009.03.003

328 countries, including dealing with exchange rate risk, political risks, legal compliance and so on, serves as an incentive to multinationals to locate production in nearby, less distant and more familiar markets. As such, firms are likely to concentrate production in the local, regional, or nearby economies. Analyzing the regional concentrations in MNE activities is important for several reasons. First, the result that MNE activities are highly concentrated in the home region is in sharp contrast to the perceptions held by many policy makers, academics, and the popular press that the activities of the worldÕs largest MNEs are global in nature – in fact bridging this knowledge gap is one of the objectives of an edited volume by Fratianni (2006). Second, it is important to determine whether these concentrations of MNE activities are sub-optimal, in which case managers must reconsider their global strategies, and policy makers would need to better understand the extent to which changes are needed that would allow multinationals to optimize. On the other hand, to the extent those concentrations can be shown to be consistent with profit maximizing corporate strategies, than that would reassure managers, shareholders and policy makers that in fact multinational global strategies are consistent with the environment they operate in. Therefore, whatever the outcome, this empirical regularity must be better understood. Existing studies have considered the activities of the worldÕs 500 largest MNEs, the sample of all US MNES, and the trade and FDI patterns of OECD countries, as well the activities of MNEs from several developed countries. There are no published studies that focus on the regional and global character of MNE activities into China. The Chinese case is incredibly important given the phenomenal growth experienced by China, its size, and the importance foreign investment has played in its growth experience (Whalley and Xin, 2006). Also, given the debate around the role of government in ChinaÕs rapid rise (Girma et al., 2008) leaves open the question as to whether the factors that explain FDI with China is consistent with explanations found to explain such relationships with North America and Europe. Answering this question therefore sheds light on the broader question as to whether emerging economies require a new theory of internationalization, or whether current theories apply. This paper uses data from the China Fiscal Yearbook to analyze the patterns of FDI into China from up to 203 countries, over the period 1995–2005. These patterns indicate that, consistent with previous evidence from developed countries, multinational activity into China is regionally biased. That is, there is significantly more FDI into China from the Asia Pacific Region than would be predicted from simple benchmarking. The results of this analysis indicate that Hong Kong and the Virgin Islands account for a significant share of FDI into China. It is obviously the case that the significant FDI moving through these economies into China originates in third countries, likely in Europe and North America. The results indicate that even after accounting for these special relationships, there remains a regional concentration of FDI into China: that is, ChinaÕs MNE activity shares a similar regional character as seen in OECD countries. The outline of this paper is as follows. Section 2 provides a background discussion of these issues and provides a brief

W. Hejazi review of the literature. Section 3 develops the hypotheses. Section 4 describes the regional distribution of FDI into China and tests some simple benchmarking hypotheses. Section 5 presents the transactions cost model underlying our analysis, namely the gravity model. Section 6 presents empirical results, and Section 7 concludes.

Background In a series of papers, Rugman and several of his colleagues have demonstrated convincingly that, contrary to widespread beliefs that multinationals are globally oriented, they are generally speaking regional. Rugman and Verbeke (2004) classify as ÔglobalÕ all MNEs with a foreign-to-total sales (F/T) ratio above 50% and/or with some significant activity in each part of the triad. Using data on the Fortune Global 500 companies (the largest companies in the world), they found that 320 of the 380 firms for which data were available, were home-region oriented, with over 50% of their sales in their home region. Twenty-five firms were found to be bi-regional, with less than 50% of sales intraregionally and over 20% of sales in two regions, including their own home regions. Another 11 firms were uni-regional in a host region, deriving over 50% of their sales in foreign regions. Only nine firms in the set were global, with less than 50% of sales in their home region and over 20% of sales in each region of the triad. There was insufficient information to classify 15 firms. To quote from Rugman and Verbeke (2004), ‘‘This means that the worldÕs largest firms are not global, but regionally based in terms of breadth and depth of market coverage. Globalization thus reflects a special, and rather unusual, outcome of doing international business, and regional strategies are more relevant than global ones’’ (Journal of International Business Studies 35(1), 2004). Rugman and Collinson (2008) consider the foreign activities of Japanese MNEs in the list of the worldÕs 500 largest MNEs. They show that 64 Japanese MNEs have data on regional sales, only three of which operate globally. On the other hand, 57 have an average of over 80 percent of their sales and foreign assets in their home region. They use data and a new framework for analyzing both downstream (sales) and upstream (production) assets to analyze why most large Japanese firms appear to have firm-specific advantages (FSAs) which are based in their home region. A structural contingency approach is applied to two case studies to explain how home region-bound FSAs constrained the ability of Japanese MNEs to implement internationalization strategies. This analysis extends that in Rugman and Collinson (2007) which focused on Asian MNEs and show that 105 out of the 115 Asian firms reporting data, only three can be considered global. There are several additional papers in this line, and the conclusion that emerges is that globalization has not resulted in firms selling their outputs or locating their activities in significant amounts across the globe. Rather these multinationals, on the whole, locate the majority of their activities inside their home region. There are two sets of questions that must be addressed. The first is whether, within the business and political environment MNEs operate, are they allocating their sales and

Does China receive more regional FDI than gravity would suggest? activities optimally? Secondly, to what extent should business and government work to enhance the environment so as to better allow firms to penetrate global markets, assuming of course this would be a profit enhancing strategy. Rugman has proposed several theories to explain the regional concentration of MNE activity, including regionbound FSAs which constrain the ability of multinationals to internationalize. The approach taken in this paper is somewhat different than these studies, but is similar to that undertaken in Hejazi (2007a,b, 2005). These papers apply a widely used transactions cost model to explain the patterns of FDI and multinational activities. The model predicts how much activity there should be between economies based on the size of each economy, distances between economies, language, cultural and legal differences across countries, and other transaction cost related variables. Hejazi (2007a) uses data on all US MNEs over the period 1980 to 2000 to establish that regional concentrations in US MNE activities are consistent with a gravity model – that is, given the costs associated with doing business in distant and foreign markets, US MNE managers allocate a large share of their activities/assets nationally and regionally. What this means is that the hypothesis put forth by Rugman on the regional nature of MNE activities is consistent with a transactions cost interpretation. This transactions cost approach has been extended to OECD countries for the operations of OECD-based multinational operating inside the OECD (Hejazi, 2007b). The activities analyzed include inward production, employment, turnover, armÕs length trade and intra-firm trade. The results indicate that these activities have a regional bias in the EU. That is, European MNEs have more activity within their region than can be predicted by a transactions cost model. The data used has limited information on North America, although for the data which is available, there is no such bias within North America. Hejazi (2005) applies this transactions cost approach to OECD trade and FDI patterns, and documents significant trade concentrations within each region, whereas in the case of FDI, there is a regional bias within the EU but not within NA. There has been a great of work on the growth of regionalization in trade patterns, much of which uses the gravity model. For example, Fratianni edits a volume of papers that works to ‘‘reduce the gap between the perception and the reality of globalization’’, where the gap is the difference in the reality that economic activity is best described as regional despite a widely held belief of globalization. As is indicated in the introductory chapter to this edited volume, distance matters, but also regional trade agreements have become increasingly important. As such, regionalization is becoming increasingly apparent in the raw data for some regions (ANDEAN PACT, MERCOSUR, and the EU and NAFTA, but declining in ASEAN). Using a definition of regionalization as trade within a region above and beyond what can be explained using a gravity model several chapters have found significant evidence of regionalization. To quote directly from Fratianni, ‘‘Based on this criterion, there is strong evidence of regionalization and the national borders have been pushed outward to encompass regional areas’’ (see Chapters 2, 5, 6, 8 and 10 of Fratianni (2006)). The edited volume has 12 chapters.

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Together the empirical evidence on this topic indicates that the Rugman hypothesis continues to hold most strongly within the EU context, even after controlling for the transactions costs associated with operating in foreign and distant markets, and to a lesser extent in North America. Multinationals tend to have a large concentration of their activities in their home region. The concentration of Chinese MNEs has been considered by Rugman and Li (2007). Since Chinese MNEs tend to be large and have few knowledge specific assets, but rather have advantages based in scale economies based on ChinaÕs country specific advantage of unskilled labor and natural resources, they will likely become knowledge seekers as they go abroad. The paper shows that most of the largest Chinese MNEs will continue to have a majority of their sales intraregionally, that is, within Asia. The paper predicts that the Chinese MNEs are highly unlikely to become global or bi-regional in the next ten to 20 years. There are currently no published studies that focus on the regional nature of MNE activity into China (i.e., inward FDI into China). This paper fills that void. Here, the regional nature of FDI locating in China will be described. Using a gravity model framework, the hypothesis will be tested as to whether FDI originating within the region is more than would be predicted using a formal model that should explain these patterns, as well as whether participation in the Chinese miracle, vis-a `-vis FDI, from Europe and North America is as the model would predict.

Hypothesis development Multinationals are firms that by definition do business across international borders. As such, the result indicating that most multinationals are not global in nature, that is their activities are significantly concentrated in their home region, may seem like a paradox. To the contrary, however, it is expected that there will be, to some extent a concentration of MNE activity certainly in the home country, but also in the home region. This section of the paper will discuss the theory underlying this prediction, and its application to FDI patterns as they relate to China. In a world where there are no transportation costs or other costs associated with doing business in distant and foreign markets, then one may expect that MNE activities will be distributed globally in proportion to GDP. For example, therefore, given that North America is 26% of world GDP (in the year 2000), then one may expect MNEs to concentrate about 26% of their activities in the North American market. Similarly, Europe is about 23% of world GDP and the Asia Pacific is about 20%, and hence these regions should receive about 23% and 20% of MNE activities proportionately. Given the extent and detail of the US data, the patterns of US MNE activities will be discussed to motivate the hypotheses tested below. US MNEs have a much larger concentration of their activities in North America than would be predicted by simply benchmarking off of GDP. The concentration of US MNE activity in North America is something on the order of three times the GDP share. More specifically, although North America makes up about 26% of world GDP, 74.56% of US MNE Sales are in North America, 69.93%

330 of Net Income, 73.68% of Assets, 77.38% of employment, and 82.36% of employee compensation.1 There are many economic reasons to expect the activities of US MNEs to be concentrated inside North America. There are significant costs associated with operating in foreign and distant markets. Therefore, in addition to GDP, other factors that must be taken into account in the explanation of the distribution of MNE activity would include distance between economies, exchange rates, language similarities, free trade agreements, as well as institutional differences/similarities. Using this Gravity Model framework, Hejazi (2007a) demonstrates that US MNE mangers have distributed their activities in each of these regions according to transactions cost considerations. That is, the amount of US MNE activity locating in Europe and the Asia Pacific are consistent with the amounts that would be predicted given the costs associated with US MNEs operating in these foreign and distant markets. Hejazi (2005) uses this framework to show that there is a regional bias within both the EU and NA with respect to trade, but in the case of FDI, there is only a regional bias in the EU. Hejazi (2007b) extends this framework to several MNE activities within the OECD region. The current paper extends the framework to the case of China. The analysis considers the activities by foreign MNEs locating inside China, and whether the distribution of these activities is consistent with the predictions of a gravity model. This gives rise to the hypotheses to be tested in this paper. Hypothesis 1. Foreign MNE activities locating inside China should be more regionally concentrated than would be predicted by only considering GDP. That is, the regional share of an MNEÕs activities located inside its home region should be higher than that regionÕs share of world GDP. Hypothesis 2. Once the costs associated with operating in foreign and distant markets are taken into account, MNE activities should be consistent with the transactions costs associated with operating across markets. The first hypothesis indicates that we expect, for example, Asia-Pacific host countries (China in this case) will receive a share of their foreign activities from other Asia-Pacific countries that is larger than its share in world GDP. The question addressed is, given that the Asia Pacific region is about 20% of the worldÕs GDP, would the share of foreign activity inside China coming from other countries in the same region be higher than the regionÕs share of world GDP? If the answer to this question is yes, then that would be evidence in favor of Hypothesis 1. Hypothesis 2, on the other hand, relates to whether the concentration of Asia-Pacific activity inside China is consistent with predictions of the gravity model. Given that China is in this region, and hence has proximity to other Asia-Pacific economies and many other factors that would explain a high degree of integration, then the question becomes whether these regional concentrations can be explained by these transactions cost considerations. 1

For details on these data and distributions, see Hejazi (2007a).

W. Hejazi These hypotheses are tested below. First, the regional distribution of FDI locating inside China is documented. Second, a gravity model is used to test whether these concentrations can be explained by a transactions cost motivation.

Regional distribution of FDI into China The FDI data into China used in this analysis come from China Fiscal Yearbook. These data represent investments inside China by foreign enterprises, economic organizations or individuals for the establishment of ventures exclusively with foreign ownership, Sino-foreign joint ventures and cooperative enterprises or for co-operative exploration of resources with enterprises or economic organizations in China. It includes the reinvestment of the foreign entrepreneurs with the profits gained from the investment and the funds that enterprises borrow from abroad in the total investment of projects which are approved by the relevant department of the government (see China Fiscal Yearbook for more details). In 1995, a full 80% of the stock of FDI in China came from Asia-Pacific economies. This share has fallen over the subsequent decade where in 2005 the share was 60%. Latin America on the other hand has seen its share rise from less than 2% to 17%, in part driven by the use of Offshore Financial Centres (OFCs), which are discussed below. Both Europe and the US have seen their shares increase over the first half of the period but have since seen their shares fall back below 10%. Although the Asia Pacific region accounts for about 20% of world GDP, 60% of FDI into China originates from East Asia. This confirms Hypothesis 1, namely that China receives a larger share of its FDI from the Asia-Pacific relative to its share in world GDP. There are two obvious complications that arise in considering these data. The first relates to the special role of Hong Kong, which has been classified by the IMF as an OFC, and the second relates to the role of OFCs in general. Much of the FDI going into China moves through these OFCs, and the special relationships between these OFCs and China must be accounted for if we are to fully understand the patterns of FDI being described. In 1995, over half of the FDI in China is recorded as having come from Hong Kong. This share fell to 30% by 2005. Taiwan is a far less significant, although still an important player. In 1995, 8% of FDI into China flowed through Taiwan. This was down to less than 5% in 2005. There are two fundamental reasons as to why Hong Kong plays a significant role in ChinaÕs FDI. First, there was a widespread practice of Chinese companies registering in Hong Kong, and then re-investing into China. This was done so as to be eligible for protections, tax and subsidy incentives, and preferences afforded foreign firms that were not extended to domestic firms. These practices are becoming less important especially with ChinaÕs accession to the WTO in 2002. Second, Hong Kong is an OFC, thus allowing firms from third countries to use it as a conduit into China. These flows of FDI through Hong Kong are subject to lower taxes than had the multinational moved into the Chinese market directly. The role of OFCs in general have been growing rapidly over the sample in question. In 1995, 11 OFCs accounted

Does China receive more regional FDI than gravity would suggest? for slightly over 1% of all FDI moving into China. The share rose to over 20% in 2005. By far, the most important OFC is the Virgin Islands, accounting for 14.32% of all FDI moving into China in 2005, followed by the Cayman Islands at 3.05% and Samoan at 2.12%. As in the case of Hong Kong, foreign firms use these conduits to access the Chinese markets because of preferential tax arrangements. Many OFCs in fact have tax treaties with developed countries and increasingly with China. This allows those multinationals to repatriate many of the revenues generated in China (and more generally in the global economy) back to the host economy with significantly lower tax obligations relative to the situation that would arise had they invested into China directly. It is important to raise the role of OFCs because although the data are recorded as moving from those jurisdictions into China, they are actually moving from third markets, most likely the US and Europe. If the special relationship between these OFCs and China are not taken into account, the regional analysis below would be biased. As such, our analysis will take into account those special relationships. The limitation of this analysis is as follows. Given we are taking special account of Hong Kong and Taiwan, then the FDI that is coming from Mainland China and reinvested back into China does not affect this analysis. What does affect the analysis is the FDI moving through Hong Kong or Taiwan that originates outside the Asia-Pacific region. However, our conclusions will relate to whether the amount of FDI into China from the Asia-Pacific region, North America and Europe are consistent with the gravity model. Given that some of the FDI is actually channeled through OFCs implies that the FDI from these three regions will be underestimated. Therefore, if we find there to be more FDI than can be predicted by the model, the bias of the OFCs would work against this. That is, if we find there to be a positive bias, that evidence will be quite strong. The objective of this paper is to measure the extent to which the FDI going into China is ‘‘overly’’ regional, that is, the extent to which there is a regional bias in terms of Asian MNEs locating into China to a greater extent than transactions would explain. As indicated above, this pattern has been established for many developed countries, but has not yet been documented in the case of China.

The gravity model The discussion above confirms the notion that MNE activities locating inside OECD countries have a relatively large participation by MNEs from the local region. That is, regional MNEs have a larger share of their activities in their own region relative to the regionÕs share of world GDP, and ChinaÕs experience with FDI is no exception. The important question that must be asked is whether these concentrations are consistent with economic theory. Given the costs associated with doing business in distant and unfamiliar markets, with different languages, institutions, and the costs associated with working outside local business networks, as well as explicit and implicit restrictions on trade and FDI, it is expected there would be more activity inside the home region. The objective of this paper is to use one benchmark, namely that predicted by the gravity model, as a test of whether the observed regional concentrations of MNE activities locating in China are consistent with economic theory.

331

The idea underlying the gravity model for trade is that countries of similar size and per capita GDP have similar needs both in terms of intermediate inputs (Ethier, 1982) and consumption patterns. Also, two countriesÕ trade should be positively related to these countriesÕ incomes, and countries that are close together and have similar languages will have smaller transactions costs of doing business and correspondingly larger levels of bilateral trade. Trade flows are also sensitive to movements in the exchange rate. Dummy variables are included for several regional groupings, and measure persistent patterns of trade within regional areas, which are not captured by the gravity variables. It is well known that the gravity model explains trade flows well, but what is relatively less well known is that there are theoretical foundations for the gravity equation. The early contributions to these theoretical developments include Bergstrand (1985, 1989, 1990), Leamer (1974), Anderson (1979). Helpman (1987) interpreted the success of the gravity model as evidence in favor of the monopolistic competition model. This was based on the belief that the gravity model was consistent with that model and not with the Hechscher–Ohlin model. However, Deardorff (1998) established that the gravity model is indeed consistent with both the Hechscher–Ohlin and monopolistic competition models of international trade, but his result was restricted to a bilateral world. More recently, the approach of Head and Ries (2005) have provided additional theoretical underpinnings for a gravity-like model. The gravity model has been used to explain bilateral trade flows among large groups of countries and over long periods of time (Feenstra et al., 2001; Frankel et al., 1995; and in several chapters of an edited volume by Fratianni (2006)). The gravity model has also been used to explain patterns of FDI (Brainard, 1997; Grosse and Trevino, 1996; Grubert and Mutti, 1991; Lipsey and Weiss, 1981, 1984; Stein and Duade, 2001). In contrast to that for trade, the gravity model for FDI has not been given theoretical foundations. As such, much of the empirical evidence must be qualified. That is, without a theoretical model underlying its derivation, the gravity model applied to FDI is a reduced form analysis whose results must be interpreted carefully. However, as in the case of trade, ongoing research has been developing empirical models for FDI that do have theoretical foundations, although these tend to be quite difficult to work with at present (Markusen, 2002). Nevertheless, one cannot say that a gravity model for FDI is without theoretical underpinnings – although it is fair to say these are not yet fully developed. Following the international business literature, the gravity model is used to explain ChinaÕs FDI patterns. The basic estimating equation can be written as follows: lnðINFDIit Þ ¼ a0 þ a1 lnðGDPHOMEit Þ þ a2 lnðDISTANCEij Þ þ a3 lnðXRATEijt Þ þ b1 ðAsia Pacifici Þ þ b2 ðHKi Þ þ b3 ðNAiÞ þ b4 ðEUi Þ þ eit

ð1Þ

where ln is the natural logarithm. INFDIit represents the FDI into China from country i in year t. The sample covers up to 203 countries over the period 1995–2005, although this sample coverage varies across countries for each year. Less than one half of the worldÕs 203 economies actually invest in China.

332 GDP measures real Gross Domestic Product of the home countries. Distance is a measure of the physical distance between countries. XRATE is the purchasing power parity exchange rate between China and country i.2 Although the expected sign on the GDP variable is unambiguous, the expected sign on both the distance and exchange rate variables are ambiguous. The coefficient on GDP is expected to be positive: the larger is a home country, the more FDI we expect to locate in China from that home country. The coefficient on distance in a trade regression is unambiguously negative because distance proxies for transportation costs. Therefore, larger distances translate into higher transportation costs, and lower trade. On the other hand, in the case of FDI, the larger are distances, costs associated with communication and intra-firm trade are larger, thus implying lower FDI. At the same time however, multinationals may undertake more FDI to over come the larger distances. Hence the net effect is ambiguous. The estimated sign on the exchange rate variable is also ambiguous. Finance theory predicts that FDI should be unrelated to movements in the exchange rate. Although a depreciation in the exchange rate reduces the cost in foreign currency to acquire domestic assets, given the revenue flow that is subsequently derived from the asset would be repatriated at a lower exchange rate, the net effect is a wash: changes in the exchange rate are expected to be unrelated to FDI. On the other hand, Blonigen (1997) shows that in the process of acquiring firm specific assets, a reduction in a host countryÕs exchange rate reduces the cost to foreign firms to acquiring these assets. Since the assets are likely going to be taken back to the home country, implying there will not be a flow of income in the depreciated currency, then in this scenario a reduction in the domestic economyÕs exchange rate can stimulate FDI. As such, given the specification being estimated here and the level of aggregation of the data, the sign on the exchange rate is ambiguous. The standard gravity model is extended to include regional dummies for North America (NA) and the European Union (EU). These dummy variables pick up any persistent deviations between the modelÕs predictions and FDI with each region. In Eq. (1) above, b3 and b4 capture whether there is more FDI in China from NA and the EU, respectively, than can be explained by the size of the economies, their distance from China, and exchange rate changes. If the estimated values of b3 and b4 equal zero, the amount of FDI from NA and the EU into China would be consistent with predictions of the model. On the other hand, if the estimated values are positive, these regions have more FDI in China than the benchmark as predicted by the gravity model would predict. The hypothesis of interest, however, relates to the whether there is more FDI into China from its own region than can be predicted by gravity, and this hypothesis relates to the estimated b1 and b2. If the estimated values of b1 and b2 are zero, there would not be more FDI in China from the Asia-Pacific region than would be predicted by the gravity model. This is a hypothesis we test below.

W. Hejazi However as indicated above, OFCs play an important role in FDI moving into China. Therefore, the gravity model above must be extended to take into account that special relationship. lnðINFDIit Þ ¼ a0 þ a1 lnðGDPHOMEit Þ þ a2 lnðDISTANCEij Þ þ a3 lnðXRATEijt Þ þ b1 ðAsia Pacifici Þ þ b2 ðHKi Þ þ b3 ðNAi Þ þ b4 ðEUi Þ þ d1 ðOFCsi Þ þ d2 ðVirgin Islandsi Þ þ eit

ð2Þ

Estimating Eq. (2) will allow us to identify the extent to which there is a regional concentration in terms of the FDI locating in China, and furthermore, whether these results are in any way driven by the special relationship that China has with Hong Kong vis-a `-vis FDI. The Rugman hypothesis that is being tested would predict that the estimated value of b1 is positive, and of course we test whether this result holds even after Hong Kong and other OFCs are taken into account. Eq. (2) is estimated using bilateral inward FDI into China. The results are discussed in the next section.

Empirical evidence The regression results are presented in Table 1. In column (1), the relationship between FDI locating into China is related to the home countryÕs GDP, distance between the home country and China, and the value of ChinaÕs currency relative to the home countryÕs currency. The estimated signs are highly significant. The coefficient on GDP is positive, as expected, indicating that the larger the home country, the more FDI there is in China from that home country. The coefficient on distance is negative, indicating that the further away is the home country the less FDI that home country will locate in China. The coefficient on the exchange rate is negative and highly significant. This indicates that the more valuable is ChinaÕs currency relative to that of the home country, the less FDI we expect to locate in China. Note that this exchange result is still operational despite the fixed exchange rate between the US dollar and the Chinese RMB, as the US is only one of many players in ChinaÕs FDI experience. The results in column (2) extend the analysis to determine whether accounting for the Asia Pacific, Europe and North America affect these results. That is, all else constant, is there more FDI into China from the Asia Pacific, Europe and North America than would be predicted based on GDP, distance and exchange rates? The results show very strong evidence indicating that all three regions, the Asia Pacific, Europe and North America have more FDI into China than would be predicted based on gravity. The Asia Pacific region has the largest coefficient, followed closely by North America.3 The size of the Europe coefficient is positive and highly significant, but much smaller than the coefficients on either the Asia Pacific or North America variables. Furthermore, although the coefficient on GDP remains positive and highly significant and the sign on exchange rates negative and highly significant, the coefficient on distance becomes insignificant.

2

There are no language and adjacency variables because they would be collinear with the Hong Kong variable which will be addressed below, and hence are not explicitly accounted for here.

3 A Chi Square test shows that the value of the NA and the Asia Pacific dummies are insignificantly different from one another.

Does China receive more regional FDI than gravity would suggest? Table 1

333

Regression results: the gravity model. 1

2

3

4

GDP Distance Exchange rates Openness to trade Asia Pacific Europe North America OFCs Hong Kong Virgin islands

0.529 (13.17) 1.342 (9.87) 0.311 (11.13)

0.367 (9.79) 0.182 (1.23) 0.293 (11.50)

0.551 (15.61) 0.187 (1.44) 0.232 (10.27)

0.654 1.072 0.263 1.096

Adj R square NOB

0.32 976

4.290 (15.24) 1.422 (7.16) 4.159 (9.52)

0.49 976

3.962 1.407 3.374 2.936 4.062 5.443 0.61 976

5 (15.00) (7.70) (9.29) (6.62)

(15.85) (8.07) (8.59) (10.66) (6.23) (8.07) 0.3523 976

0.455 0.106 0.268 0.632 4.014 1.165 4.194

6 (10.57) (0.72) (10.32) (4.06) (13.96) (5.62) (9.67)

0.4969 976

0.617 0.140 0.214 0.481 3.782 1.210 3.417 2.882 3.528 5.614

(15.41) (1.08) (9.32) (3.42) (14.89) (6.62) (8.74) (10.51) (5.29) (8.35)

0.6129 976

Note: (1) The result above are derived from a panel-fixed-effects model, and there are unreported year fixed effects and an unreported constant. (2) t Statistics are reported in parentheses, where the standard errors used in the calculations are robust to autocorrelation and heteroskadsciticy. (3) All coefficients reported above are statistically significant at the 99% level, except for distance in columns (2), (3), (5), and (6).

The results show that, controlling for other factors, the regions covered by the regional dummies – the Asia Pacific, Europe and North America – are all positive and statistically significant. However, considering only the concentrations of FDI, it would appear that only the Asia Pacific would have a regional concentration. However, the model shows that after controlling for the gravity model, the Asia Pacific, NA and Europe all invest more than is predicted by the model. This of course is not inconsistent with the regional concentration hypothesis of Rugman. That is, there can still be a regional concentration, and at the same time have other regions investing more than is predicted by the model.4 Column (3) takes into account the special relationship that China has with OFCs in general, and Hong Kong and the Virgin Islands in particular. The coefficients on all three of these additional variables are large, positive and highly significant. The coefficient on the Virgin Islands is the largest followed by the Hong Kong coefficient. These results indicate that there is substantially more FDI that goes through these OFCs than would be predicted by their size, distance from China, and the values of their currencies. This is as expected. However, what is of most interest are the coefficient on the Asia Pacific variable: it remains positive and highly significant, as do both the Europe and North America variables. The bias in the data induced by the use of OFCs in general and Hong Kong in particular would ‘‘reduce’’ the amount of FDI originating in all three regions (Asia Pacific, Europe and North America). Some fraction of the FDI originating in these home regions are being channeled through OFCs, and hence reduces the amount recorded as originating in the regions. Therefore, any evidence found of a regional bias would in fact be an underestimate. Therefore, the evidence presented here indicating that not only is there more FDI into China from the Asia Pacific than would be predicted 4

I would like to thank an anonymous referee for pointing this out.

by the gravity model, but that there is also more FDI in China from both Europe and North America. One of the major motivations for Western and Asian multinationals to locate in China is to access the vast supply of low-cost labor. It may be expected therefore that how open an economy is to international trade generally would likely predict the extent to which these economies have engaged China in terms of FDI. To address this possibility, the gravity model is extended to include Openness to Trade as another determinant to FDI into China. These results are reported in columns (4)–(6) in Table 1. The results are quite strong, and indicate that Openness to Trade is an important factor attracting FDI into China, and suggests that multinationals from the more open economies have engaged China vis-a `vis FDI to a greater extent than those that are less open. The robustness of the results above must be highlighted. With the exception of the distance variable, the coefficients and their significance are not qualitatively affected by the addition of either the regional or OFC dummies, as well as the Openness to Trade variable. The relationships identified here are therefore quite strong and robust.

Conclusions It can now be considered an empirical regularity that the activities of multinational enterprises are concentrated in their home region. This has been shown to be the case for the sample of the worldÕs largest multinationals, subsets of those countries stratified by industry and region, as well as for the activities of the MNEs operating in OECD countries. There are currently no published papers on the activities MNEs locating inside China. This paper works to fill that void. Using data on FDI into China from all reporting countries, this paper documents a significant regional concentration of FDI: a large share of FDI locating in China comes from countries within the Asia Pacific region (60% in 2005). A closer

334 look however identifies that half of these stocks come from Hong Kong. Furthermore, a full 20% of FDI stocks in China came through conduit jurisdictions, known also as OFCs, the most important of which is the Virgin Islands which accounted for 14.32% of all FDI moving into China in 2005, followed by the Cayman Islands at 3.05% and Samoan at 2.12%. As in the case of Hong Kong, foreign firms use these conduits to access the Chinese markets because of preferential tax arrangements. Many OFCs in fact have tax treaties with developed countries and increasingly with China. This allows those multinationals to repatriate many of the revenues generated in China (and more generally in the global economy) back to the host economy with significantly lower tax obligations relative to the situation that would arise had they invested into China directly. The analysis shows very clearly that even after accounting for the special relationships with OFCs in general and Hong Kong in particular that there is a significant regional bias underlying FDI in China. Using the gravity model as a benchmark indicates that MNEs from the Asia Pacific region invest more in China (excluding investments from Hong Kong, either directly or indirectly) than is predicted. Therefore as in the case of Europe and North America, multinationals in the Asia Pacific region are more regionally focused vis-a `-vis China than is predicted based on transactions costs. Returning to the question raised in the announcement of this special issue, and noted above, the analysis presented here has shed light on the broader question as to whether emerging economies require a new theory of internationalization, or whether current theories apply. The analysis presented demonstrates that the regional nature of FDI into China is similar to that documented for North America and Europe, thus indicating a new theory is not needed. The regional character of MNE activities entering China are similar to those that characterize MNE strategies accessing both Europe and North America. An additional result to highlight is that even after controlling for the 20% of FDI that moves through OFCs, which likely originates in Europe and North America, there remains more FDI in China from both Europe and North America. This implies therefore that participation in China by global multinationals is broadly based. That is, MNEs from Europe, North American and the Asia Pacific region invest more into China than a gravity benchmarking analysis would predict. This therefore confirms wide participation in ChinaÕs development vis-a `-vis FDI.

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Whalley, J., & X. Xin. (2006). ChinaÕs FDI and Non-FDI economies and the sustainability of future high Chinese growth. NBER working paper no. 12249, May. WALID HEJAZI is a Professor of Business Economics at the Rotman School of Management at the University of Toronto where he regularly teaches CanadaÕs current and future business leaders in the MBA and EMBA programs. He has published extensively in more than 40 business journals and publications. In keeping with the spirit of Rotman, Walid balances his research activities by helping many of CanadaÕs leading organizations leverage research to decide new strategies and initiatives. Recently, he has assisted several large retail chains find new ways to understand their market data, providing them with perspectives that have allowed them to optimize their marketing activities, reduce their inventory holdings, and develop criteria that ensures successful location selection. Walid has also consulted for several branches of Canadian government, on diverse themes such as the competitiveness of the Canadian economy and international trade. He is currently editor-in-chief of a study being prepared by the Department of Foreign Affairs that measures gains from a closer economic partnership between Canada and the EU.