A simultaneous equation model of economic growth, FDI and government policy in China

A simultaneous equation model of economic growth,
FDI and government policy in China


J. L. Ford*, Somnath Sen* and Hongxu Wei*

July 2010


Abstract: Empirical investigations aimed at determining what relationship, if any,
exists between FDI and economic growth has drawn ambiguous results. This is also
the case for China, where all empirical studies have used the VAR methodology. In
this study we outline a dynamic simultaneous equations model. The model captures
the interrelationships between, aggregate output, domestic capital, FDI, human capital,
and the state of technological development. As well as broadening the formulation of
the production function, the model is defined to include possible influences from
government capital expenditure on the infrastructure. Structural equations are then
developed to determine those variables, and further factors are introduced into the
model thereby, such as saving and wealth, and other exogenous policy variables. The
latter embrace monetary, commercial and fiscal policy. Two of the potential influences
on the system, and hence upon economic development, are financial liberalisation and
the general opening-up of the Chinese economy, since 1979. The dynamic multipliers
from the estimated model indicate, amongst other things, that the general set of
economic reforms has beneficial impact on long-run economic growth, directly and
indirectly by its enhancement of FDI.


Keywords: economic growth factors, FDI, spill-over effects of FDI, monetary policy,
commercial policy, fiscal policy, “opening out” reforms, GMM estimates, multipliers.

JEL Classification: O23, O24, F23

*Department of Economics, University of Birmingham, B15 2TT, UK

Corresponding author: j.l.ford@bham.ac.uk ; `phone, +44(0) 121 414 6638: FAX, +44(0)
121 414 7377.

---

A simultaneous equation model of economic growth,
FDI and government policy in China
1. Introduction
China’s success in improving its economic growth and attracting foreign
capital has generated several studies which have endeavoured to assess the role FDI
has played in the country’s economic development. However, the research has failed
to establish a consensus on the relationships between aggregate output, FDI and other
possible ancillary output-inducing mechanisms. For instance, employing time series
analysis, Tan et al (2004) detected a direct relationship between FDI and GDP and
found that the effect is small but significant. Su (2005) analyzed the relation between
FDI, domestic investment and output and concluded that FDI enhances output, but has
only a limited impact on domestic investment. Liu et al (2002) focused on the link
between FDI and economic growth through international trade. Shan (2002), also
relying upon a VAR model, used the technique of innovation accounting to generate
the relationship between FDI with output via labour, investment, international trade
and energy consumed. The main findings were that output has not been caused
significantly by FDI but, rather, has been an important determinant of it. One of the
reasons the ambiguity in the findings is that the studies focused on one or several
different channels through which FDI might affect the macro-economy, but
concentrating predominantly on uni-directional impact effects.
A more comprehensive framework, in the form of a simultaneous equations
system, is required to assess those possible interactions. This should incorporate not
only real aggregate output (or economic growth depending upon the appropriate order
1

---

of integration of the variables demanded by the econometric framework) and FDI, but
also on the supply side: the potential spill-over effects from FDI (for example, see
UNCTAD (1992), UNCTAD (2003) and Chudnovsky (1993)); labour supply;
domestic capital formation; and, measures of the technology level in the economy. All
of those variables might be considered to be endogenous. To them should be added
further endogenous variables that might inter-relate with them: saving and wealth,
possibly important indicators of the sources and availability of finance for capital
investment (so that the sole reliance on the accelerator mechanism as the determinant
of investment is removed); and, the stock of human capital, emphasised by
endogenous growth theory. However, just as important, is the set of exogenous
variables that might determine the vector of endogenous variables.
Those exogenous variables should include policy variables and indicators of the
changing backdrop to the economy over the years. That backdrop is of paramount
importance in the case of the Chinese economy. Both these considerations are
accommodated in the model which we formulate and analyse in this paper. In respect
of government policies as such, we incorporate central aspects of monetary, fiscal and
commercial policy. Those key indicators of such policies, taking seriatim, are
captured by “the” interest rate, tax revenues and expenditure on education and the
infrastructure, and by the inclusion of the exchange rate. For example, the interest rate
can be a surrogate for Tobin’s q and together with saving and/or wealth might be a
significant influence on domestic capital formation, especially as the economy
became more liberalised over the years.
2

---

In regard to the “backdrop” to the economy, we are thinking of the changes that
have been made in what has been called the “opening out” of the Chinese government
since 1979. Although the government has reduced its intervention in the economy
since that time, it still exercises a strong influence in the economic sphere. The
reforms that it has instituted have, over the years, increasingly liberalised the financial
and commercial sectors; and have opened up the economy to international trade and
to FDI. We endeavour to capture those forces by the use of several variables; one of
which is a dummy variable that tracks the increasing openness of the Chinese
economy of the years since 1979. Other variables reflect more immediately the
reforms in the financial sector (such as the volume of bank credit).
Just as there has been some, albeit restrictive, work assessing the role of FDI in
economic development in China, it must be acknowledged that some research has
been conducted on the impact of policy variables on the Chinese economy. For
example, Dickinson and Liu (2005) tested the effects of the interest rate on output.
Lardy (1992), as well as Zhang (1998), showed that China’s exchange rate policy is
closely related to foreign trade targets. The OECD (2000) concluded that there is a
positive role of openness, physical and technology infrastructure in improving
economic growth through increased productivity, as well as in attracting FDI inflows.
However, as with the VAR studies noted earlier on the economic growth – FDI nexus,
nearly all of those studies about government policies have either only discussed the
direct correlations of particular policy variables with economic growth without FDI,
or focused on FDI policies and their indirect effect on economic growth.
3

---

So our paper is an attempt to repair the drawbacks in both types of study on
China. In doing so, we combine into one system the variables that have been used in
both varieties of enquiry, as well as including further variables: and with a set of
exogenous variables we move to a simultaneous equations system (following the kind
of framework used by Bende-Nabende and Ford (1998) in their study of economic
growth in Taiwan). We have estimated our system by 3SLS and by GMM; and we
report the estimates from the application of GMM since these were the best on all
criteria, as we will note. The system is a dynamic one, and so we provide the
multiplier effects arising from the exogenous, and therefore also from some of the
policy, variables upon the endogenous variables. Those of special interest being those
related to the impacts of real aggregate output and FDI.
In sum: we are seeking answers to these kinds of questions: What kind of
economic polices, or economic governance, will be beneficial to economic growth,
directly or indirectly? Will these be maintained in the long run? Will government
policy affect FDI? If so, through what channel? Will FDI enhance or hinder economic
growth? Do spill-over effects influence economic growth? Are they affected by
particular government policies and intervention?
The remainder of this paper is divided into three major sections. Section 2 sets
out the specification of the system, discusses the variables, and their measurement.
The graphs of the endogenous variables are not given separately, since they appear
later in Figures 1-7. Section 3 sets out our econometric methodology and reports
overall diagnostic statistics from our estimates that justify its application to our
4

---

system. Our empirical results are reported and analysed in Section 4, with emphasis
on the important questions regarding the links between GDP and FDI, and so on. This
is followed in Section 5 by consideration of the impact and dynamic multiplier effects
generated from the estimates; which enable us to see the impact of specific exogenous
variables, such as government fiscal policies, on GDP, FDI and the other endogenous
variables. Section 6 summarises our discussion and analysis. Appendix A contains
time-series plots of the exogenous variables used in the estimation, as will be noted as
appropriate. Appendix B provides details of the “liberalization” variable that we used
in the econometrics. Appendix C provides some technical observations on the
alternative estimators to GMM upon which we report here. We employ stationary
variables and Appendix C is particularly concerned with the employment of I(1)
variables in estimation of a simultaneous equation model, using 2SLS, and the
uncovering of cointegration vectors (Hsiao 1997a, 1997b).

2. Modelling economic growth, FDI and Government intervention
This attempt to model the economic growth in China is influenced, as remarked above,
mainly by endogenous growth theory and the existence of positive spill-over effects
under the theory of international production. Our model is motivated by the study by
Bende-Nabende and Ford (1998) of economic growth in Taiwan. The central building
block in the model, following endogenous growth theory, is that the growth of output
is a function capital formation, employment, FDI, and the indirect benefits that FDI
embodies, such as, human resources development, new technology transfer (see
5

---

Solow (1970), Lucas (1988), Romer (1990)), and the opening up of the economy to
international trade. Those endogenous variables are then determined by the exogenous,
largely, government policy, variables.

The model, containing 9 endogenous variables and 10 exogenous variables, is in
general format:
GDP = f (KAP, EM, HK, FDI, TTECH, SAV, libdummy, gtran) (2.1)
KAP= f (GDP, OPEN, FDI, SAV, interest, bc, libdummy, tax) (2.2)
EM= f (GDP, HK, OPEN, FDI, interest, inflat) (2.3)
HK= f (GDP, FDI, TTECH, SAV, interest, gtran,gee) (2.4)
OPEN= f (GDP, KAP, EM, HK, TTECH, interest, pc, rmb, inflat, libdmmy) (2.5)
FDI= f (GDP, HK,OPEN, TTECH, interest, pc, rmb, wage, libdummy, tax, gtran)(2.6)
TTECH= f (GDP, KAP, OPEN, FDI, rmb,gee) (2.7)
SAV= f (GDP, EM,WEALTH, interest, pc, tax) (2.8)
WEALTH= f (GDP, OPEN, SAV, interest, bc, inflat) (2.9)
The notation and measurement of the variables (all are annual figures) is as follows.
We begin with the endogenous variables. All real variables are measured in 1990
prices. GDP is real GDP; KAP is real domestic capital formation, since data on the
stock are not available. Research on the impact of capital stock on economic growth
has often used the investment figure as a proxy for the stock (for example, see
Balasubramanyam et al. (1996(a), 1966(b)), Li and Liu (2005), and Greenaway et al
(2007)). However, following Jorgenson (1973) and (1980), we constructed a series of
the capital stock, using capital formation. However, the resultant series produced
almost identical statistical results to those reported here, so we used the published
figures of capital formation; EM is employment, measured by the annual average
6

---

employment; HK, human capital, is the ratio of student enrolment in secondary
education normalized by the population in the appropriate age cohort. The latter
variable is calculated as the product of total population and the birth rate of the
relative year; OPEN is an indicator of the openness of the economy, and is measured
as the sum of real exports and real imports of goods and services. In some studies this
is used as a ratio to GDP. However, with the latter being one of the dependent
variables in the system the ratio is not used to eliminate spurious correlation; TTECH
is a measure of imported technology in real terms. Again it is not entered in the
system as a ratio to GDP; SAV is real saving; and, WEALTH is the stock of real
wealth.
The exogenous variables, which are always referred to in lower case, and where
relevant are measured in 1990 prices, are:
interest: the one year deposit rate in state-owned banks;
bc: bank credit, taken as the total credit advanced by state-owned banks;
pc: credit advanced by state-owned banks to private sectors, and is used to measure
financial liberalization and deregulation in China;
rmb: the average nominal exchange rate, measured as RMB per dollar;
inflate: the inflation rate based on the 1990 price index; wage, this is the relative wage
rate between China and Japan, measured as a ratio of annual average wage paid in
China to that paid in Japan;
libdummy: the dummy variable is introduced to capture the economic reform process
that commenced in the late 1970s. That process is a very cautious and gradual one,
7

---

now lasting over last 30 years. So that it cannot be captured by a standard (0,1)
dummy variable. It has been a process which began slowly then took off a more rapid
pace as the reforms were accepted as they were seen to be effective, until recent times
when their pace was decelerated: as it were when diminishing returns began to emerge.
So some kind of ogive function we might surmise is the most likely form of the
dummy variable. The main objective of the reform is to liberalize international trade,
private businesses in the domestic sector, and the foreign sector. Indeed, many of the
reforms have been to provide incentives to encourage MNEs to invest in China. The
reforms have included innovatory legislation, policy and strategy change, and it can
be argued that the legislation related to FDI mirrors the progress of the liberalization.
Consequently, we constructed a time series dummy variable as the percentage of that
legislation employed by the end of each year to the sum of liberalization legislation
made during 1970 to 2006 (details are provided in Appendix C). The result is, as it
happens, something approaching an ogive function (Appendix C);
tax: the total amount of real tax revenues collected by government;
gtran: infrastructural expenditure by the government on economic sectors,
including transport and communication network;
gee: Government spending in the education sector.
The data have been assembled from: the UNSTATS database; the China
Statistical Yearbook and the Japanese Statistical Yearbook. The logarithms of all the
endogenous variables have been employed in the estimation, as have those of the
following endogenous variables, education spending, infrastructural expenditure, tax
8

---

revenues and financial liberalisation.
Before making some comments on the relationships in the system, we consider
the exogenous variables that form part of our extension of current work on our topic.
Those variables are predominantly government related, but can be classified into three
categories: monetary policy variables, commercial policy variables, and fiscal policy
variables.
Among the monetary variables, it is through the interest rate and the volume of
bank credit that the central bank endeavours to influence the economy and financial
markets (See Dickinson and Liu (2005), Montes-Negret (1995). Credit granted by
state-owned banks is a key monetary instrument in China. The central bank has the
authority to allocate quotas of credit to state-owned banks. Since banks can only
conduct business within their quota, this system allows the central bank to adjust the
money supply by raising or reducing the total credit to banks. Though the targets of
monetary policy are not explicit, according to Zhou (2007), to sustain economic
growth, one of the main targets for monetary policy is the money supply M2. It is not
clear whether the central bank targets inflation. However, we introduce inflation as an
exogenous variable in our system. The exchange rate in China is fixed in terms of US
dollars to facilitate international trade at most of times (and in 2006 it was announced
that the rmb would be pegged to a basket of currencies), and in our period of study,
only changed to balance international trade (Zhang 1998).. We treat it as an
exogenous variable in our model.
Commercial policy variables combine three variables, trade liberalization,
9

---