Economic Growth, Industrial Development and Inter-Regional Spillovers from Foreign Direct Investment: Evidence from China

Economic Growth, Industrial Development and Inter-Regional Spillovers from
Foreign Direct Investment: Evidence from China


Puman Ouyang
Department of Economics
Syracuse University
110 Eggers Hall
Syracuse University
Syracuse, New York, USA, 13244
December 2009




Abstract

Evidence from many countries indicates that foreign direct investment (FDI) typically
concentrates in a few regions within the host country. This paper examines the extent and
possible mechanisms by which spatially concentrated FDI in a developing country boosts
economic growth in other regions. Using a dataset that covers 96% of Chinese cities from 1996 -
2004, this paper finds that “inter-regional spillovers” from FDI concentrated in China’s coastal
regions have a positive and significant effect on the growth of inland regions. In addition, such
spillovers rely on an inland city’s industrial development, consistent with a role for backward
and forward linkages.




JEL classification: F21, R12, O40, O14, O18
Keywords: Foreign direct investment, Regional inequality, Spillovers, Industrialization, Growth,
China


______________________________________________________________________________
Email address: pouyang@maxwell.syr.edu Tel.: +1-351-559-8569. Fax: +1-315-443-1081. Address: 110 Eggers Hall,
Syracuse University, Syracuse, New York, USA, 13244. I thank my advisors, Mary E. Lovely (Chair), Jeffery D. Kubik,
and Devashish Mitra, for their advice and encouragement. I also acknowledge J. David Richardson and Donald. H.
Dutkowsky for their useful suggestions. I have also benefitted from comments by Alexander Bogin, Fariha Kamal,
Reshad Ahsan, Jeong Eun Shin, Asha Sundaram, and Can Uz at Syracuse University and Karen Westmont in Urban
Strategies Council in Oakland.

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1. Introduction
Many developing countries show continuous enthusiasm for attracting foreign direct
investment (FDI). Country-level and firm-level studies generally support the view that FDI increases
economic growth by bringing physical capital, advanced technology, and management expertise. In
many countries receiving such investment, however, FDI is geographically concentrated in a few
areas. For example, 90% of China’s FDI inflows consistently cluster in coastal regions, which
account for 40% of the population and 30% of the land area. Similarly, between 2001 and 2005, five
states attracted 65.5% of India’s FDI inflows while the other twenty Indian states received little FDI.1
A similar pattern appears in Brazil, Indonesia, Lithuania and Russia.2 This spatial concentration
raises concern that FDI inflows lead to unbalanced growth. Studies focused on the correlation
between a region’s economic growth and its own FDI inflows suggest that growth from spatial
concentration of FDI widens income inequality across regions within a FDI recipient country.3
A big part of the growth impact of FDI is ignored in the existing research: FDI concentrated
in a few regions may contribute to the economic growth of other regions, a phenomenon referred to
as inter-regional spillovers. Evidence from urban areas suggests that an agglomerated economy
affects its neighbor’s economy (Henderson (2003); Rosenthal and Strange (2008); Rosenthal and
Strange (2003)). A similar conclusion is drawn from studies on a larger geographic scope. Brun et al.
(2002) and Zhang and Felmingham (2002) find that China’s coastal economy has a positive impact
on inland economic growth and speculate that coastal FDI may be one reason. So far, the studies on
inter-regional spillovers from FDI are limited. One exception is Madariaga and Poncet (2007) who
use spatial econometric techniques to find that a Chinese city’s income is positively affected by FDI

1 See Nunnenkamp and Stracke (2007). In 2001-2005, almost 26 % of overall approved FDI was located in
Maharashtra, followed by Delhi (13.6 %), Karnataka (11.3%), Gujarat (8.3%) and Tamil Nadu (6.3%). Aggarwal
(2005) and Purfield (2006) have a similar discussion.
2See Blalock and Gertler (2009), Broadman and Recanatini (2001), Javorcik (2004) and Sjöholm (1999).
3 See Fujita and Hu (2001), Ng and Tuan (2006), Nunnenkamp and Stracke (2007) and Zhang and Zhang (2003).
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in surrounding cities, over the period 1990 – 2002. Their results provide evidence for spillovers
within a relatively small geographic area, possibly only among FDI abundant coastal cities.
This paper uses Chinese city data to examine the extent and mechanisms by which FDI
concentrated in coastal regions boosts economic growth of FDI scarce inland regions. For many
developing countries, the growth effects of FDI concentrated in a few FDI scarce regions may
determine the desirability of a liberal FDI policy. More importantly, the revelation of spillover
channels may have policy implications for the way in which FDI scarce poor regions gain from
concentrated FDI. In the case of China, while applying favorable policies to coastal regions for
attracting FDI, China’s regional development policies rely on fast coastal growth to drive economic
growth in poor inland regions. The analysis of growth effects of coastal FDI on inland cities sheds
light on the effectiveness of these policies and on the channels through which inland regions benefit
from distant coastal FDI.
Coastal FDI may promote growth in inland regions through several channels. Firstly, coastal
FDI stimulates internal migration because coastal foreign firms pull surplus labor from inland
regions.4 When skilled migrant workers who once worked for coastal foreign firms move back to
inland firms, technology spillovers may be generated. 5 Remittances from migrant workers also
increase inland rural household income and agricultural productivity.6 Secondly, coastal FDI may
develop inter-industrial linkages with inland firms, providing inland firms opportunities to gain scale
economies and productivity improvement through links in the supply chain.

4 Cai and Wang (2003) show that in 2000 there were 124.6 million internal migrants in China, of whom 73.4% were
inter-provincial migrants. The eastern provinces are the main destination for inter-regional migrants. More than 60%
of immigrants in eastern provinces were from inland regions. Bao et al. (2007) find that when real FDI rose by 1%,
internal migration rose by over 1.25% during the 1990’s.
5 Fosfuri et al. (2001) and Görg and Strobl (2005) suggest that labor turnover is an important channel for technology
spillovers from FDI. Cheung and Lin (2004) find evidence for this in China.
6 See Du et al. (2005) and Rozelle et al. (1999).
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This paper estimates the level of FDI inter-regional spillovers and puts a great emphasis on
assessing a potential channel for this type of spillovers: inter-industrial linkages between coastal FDI
and inland mining and manufacturing. Firm level studies, including Javorcik (2004), Kugler (2006)
and Liu (2008), find that domestic manufacturing firms improve productivity through backward and
forward linkages with downstream and upstream foreign firms in the supply chain. China’s inland
regions are suppliers of abundant natural resources and intermediate goods to industrial activities in
coastal regions. Therefore, industrial development enhances an inland region’s absorptive capacity
for receiving spillovers from coastal FDI.
China is a useful setting for the study of inter-regional spillovers. It has a large land area and
substantial geographic variation in economic activity. In addition, China displays apparent FDI
spatial concentration and regional income inequality. This study uses a dataset that covers 277
Chinese cities, including prefectural level cities and municipalities during the period 1996 – 2004. 7
The data coverage is expansive, including 96% of prefectural-level cities and municipalities, 92% of
GDP and 76% of FDI inflows in mainland China during the sample years.8 Compared with studies
based on Chinese provincial data, city-level data has advantages for studying regional spillovers. The
city is the unit of analysis in many economic geography theories (Brun et al. (2002); Neary (2001)).
Empirically, city level data allow us to control for unobservable city specific factors that affect
economic growth. Finally, more geographically disaggregated data can reduce measurement error
(Hanson (2005)).
To explore the possibility of spillovers from coastal concentration of FDI, I divide the

7 Mainland China is composed of 31 provincial level administrative districts since 1997, including 23 provinces, 5
autonomous regions, and 4 municipalities. In this paper, all provincial level administrative districts are called
“provinces” for simplicity. Prefectural level cities are administrative units under provinces and autonomous regions.
A typical prefectural level city is composed of urban and rural areas.
8 Hong Kong, Taiwan, and Macau are not included as these economies and their governance structures differ from
the mainland.
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sample into two groups: 107 coastal cities and 170 inland cities.9 I then construct measures of
effective coastal FDI to which an inland city could be exposed, using weights based on the city’s
distance to coastal FDI. Two stage least square (2SLS) fixed effect models are employed to
estimate the magnitude of inter-regional spillovers from FDI in coastal cities and to assess
whether the development of an inland city’s mining and manufacturing industries affects the
city’s absorption of spillovers from coastal FDI.
The analysis suggests that a 1 billion yuan increase in effective coastal FDI is associated
with almost a 0.058 percentage point increase in the growth rate of an inland city. Another way to
interpret the results is that a one standard deviation increase in effective coastal FDI raises the
average growth rate of an inland city from 9.6% to 12.7%. In addition, the extent of FDI regional
spillovers depends on industrialization. Highly industrialized cities gain most from coastal FDI,
while less industrialized cities appear to be unable to absorb spillovers from coastal investment. I
also find that FDI in eastern coast has the largest impact on the growth of inland regions. This
may be due to a relatively lower concentration of processing trade in eastern provinces. Ordinary
trade generates larger inter-industrial linkages with inland regions than processing trade as the
latter is based largely on processing imported inputs.
The following section provides a brief introduction to the existing related literature. Section 3
provides a theoretical framework and a description of the econometric specification. Data and
econometric issues are discussed in Section 4. Section 5 provides estimation results and robustness
checks, and Section 6 concludes.


9 Cities in coastal provinces are defined as coastal cities. Coastal regions include 12 provinces: Beijing, Fujian,
Guangdong, Guangxi, Hainan, Hebei, Jinagsu, Liaoning, Shandong, Shanghai, Tianjing, and Zhejiang. Cities in
inland provinces are defined as inland cities. Inland regions include 18 provinces: Anhui, Chongqing, Gansu,
Guizhou, Heilongjiang, Henan, Hubei, Hunan, Inner Mongolia, Jiangxi, Jilin, Ningxia, Qinghai, Shaanxi, Shanxi,
Sichuan, Xinjiang, and Yunan. Tibet is not included due to missing data.
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2. Previous Studies
2.1. FDI and Economic Growth
To date, both country-level and firm-level empirical studies confirm that FDI has a positive
impact on economic growth in certain situations. Borensztein et al. (1998) is a representative country
level study. The authors use data from 69 developing countries from 1970 to 1989 and find that FDI
is a driving force for economic growth if a host country’s human capital stock exceeds a certain
threshold. Firm-level studies focus on micro-level mechanisms for FDI’s growth impact. These
studies do not find that the entry of foreign firms necessarily improves the productivity of domestic
firms in the same industry. While Keller and Yeaple (2008) find evidence for positive and significant
horizontal spillovers in U.S. data, Aitken and Harrison (1999) and Djankov and Hoekman (2000) find
little evidence for this effect in Venezuelan and Czech firm-level data. However, there are a
considerable number of studies that support the existence of “backward” spillovers, which occur
when foreign firms teach more advanced technology to their upstream suppliers of domestic
intermediate goods, and “forward” linkages, which occur when foreign firms sell better intermediate
goods to downstream domestic firms. Representative studies include Javorcik (2004), Kugler (2006)
and Liu (2008). The authors use firm-level data from Lithuania, Columbia and China, respectively,
and find a positive impact of FDI on domestic firms’ productivity.
In spite of the positive growth effect of FDI, regional studies find that within the recipient
country, the spatial concentration of FDI leads to unbalanced development, widening the inter-
regional income gap. Fujita and Hu (2001), Jian et al. (1996), Lin and Liu (2000), Zhang and Zhang
(2003) find this in Chinese data. Nunnenkamp and Stracke (2007) confirm it with Indian data. These
papers focus only on the correlation between a region’s economic growth and its own FDI inflows.

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2.2. Inter-Regional Spillovers
There are a few studies of inter-regional spillovers from FDI. Girma and Wakelin (2002) use
firm-level data in UK and find that domestic firms are not positively influenced by foreign firms in
other regions. Girma and Gong (2008) use state-owned enterprises (SOE) data in 1999 – 2002 from
China and do not find foreign firms affect SOEs in other regions. The results are not surprising in
light of Hale and Long (2006), who find that FDI promotes the performance of private firms but not
the performance of SOE. Madariaga and Poncet (2007) find that FDI inflows affect economic growth
in surrounding cities in Chinese city-level data in 1990 – 2002. Madarianga and Poncet use
geographic proximity as a weight to discount surrounding FDI influencing a city. However, they
assign long distances a zero weight, resulting in estimates of inter-regional spillovers over a relatively
small geographic area, possibly identified by FDI-abundant coastal cities. Consequently, while
Madariaga and Poncet provide evidence of geographically-mediated spillovers from foreign
investment, their study does not provide evidence on the ability of coastal FDI to promote growth in
the inland economy.
Other factors, including economic growth, R&D and export activity, have received study as
the source of inter-regional spillovers. Brun et al. (2002) use a panel dataset of Chinese provinces
during the period 1981 – 1998 and find that economic growth in coastal regions has a positive impact
on economic growth of inland regions. Zhang and Felmingham (2002) divide China into coastal,
central, and western regions and estimate growth equations for each region by including growth rates
and FDI inflows of other regions as independent variables. They find economic growth and FDI of
coastal regions have positive spillovers on the inland regions’ economic growth. However, both Brun
et al. (2002) and Zhang and Felmingham (2002) suffer from endogeneity problems in their
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specifications. Since inland regions’ economic growth affects economic growth of coastal regions as
well, there is a reverse causality problem. Therefore, their estimated growth spillovers may be biased.
A number of studies on inter-regional spillovers focus especially on research and
development (R&D) activities. Representative studies include Bronzini and Piselli (2009), Funke and
Niebuhr (2005), Keller (2002) and Kuo and Yang (2008). Kuo and Yang (2008) use provincial-level
data in China and find inter-regional spillovers from knowledge capital. Although the authors
mention FDI as an important medium for knowledge capital, they do not focus on the estimation of
FDI regional spillovers. Fu (2004) focuses on export activity rather than R&D. Using Chinese
provincial data from 1990 – 1999, she finds no evidence of spillovers from coastal export activity
into inland regions. She argues that this is because nearly half of export activity in coastal provinces
is processing trade that does not provide inter-industry linkages to inland regions.
2.3. Absorptive Capacity
Researchers find that the magnitude of FDI spillovers relies on absorptive capacity of a firm
or a country. Borensztein et al. (1998) and Kuo and Yang (2008) find that human capital is an
important aspect of the capacity to absorb spillovers from FDI and R&D. Alfaro et al. (2004) show
that financial market development determines the extent to which a country can absorb spillovers
from FDI, while Durham (2004) and Kinoshita (2000) show that R&D expenditure is another
determinant of a region’s absorptive capacity. Some studies on absorptive capacity focus on the
“technology gap” between domestic firms and foreign firms. Representative studies include Girma
(2005), Girma and Görg (2002), Girma et al. (2001), Glass and Saggi (1998) and Kokko et al. (1996).
These studies verify that a firm’s technology level influences the extent of spillovers it can get from
foreign firms.

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3. Theory and Specification
Following decades of industrial development under the centrally planning economy, the
economies of China’s inland provinces are heavily concentrated in mining and heavy industries,
with most light industries on the coast. There are two main reasons for this pattern. At the
beginning of its founding in 1949, China feared potential foreign military attacks and, hence,
allocated heavy industries in distant inland regions. Within inland provinces, the geographic
distribution of natural resource reserve is quite uneven. Inland regions have substantial natural
resources and, thus, have a natural advantage as the location for mining industries.
Foreign direct investment has concentrated in coastal regions of China. Coastal regions have
obvious geographical advantages for export-oriented FDI (Liu et al. (2001)); Zhang and Felmingham
(2001)). Coastal regions also offer larger domestic markets for foreign firms serving local customers
(Amiti and Javorcik (2008)). Finally, China’s gradual reform policy favored coastal regions with
special economic zones and preferential tax treatments (Branstetter and Feenstra (2002)). Statistics
from Chinese Provincial Yearbooks document this spatial concentration of FDI in China.10 Figure 1
illustrates the clustering of FDI inflows in China over the period 1996 – 2004. China is landlocked on
the west and the north. Coastal regions are mainly on the east and the south. The most attractive
provinces for foreign investors are along the coast. Figure 2 shows increasing coast-inland disparity
in terms of total FDI inflows. Coastal provinces attracted 5.14 times more FDI than did inland
provinces in 2004.
Due to this regional specialization, production requires massive and frequent transactions
between coastal and inland provinces. In spite of some degree of protectionism by local
governments who erect internal trade barriers to protect local firms from outside competition,

10 Available at www.chinadataonline.com, authorized by the National Bureau of Statistics of China.
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inter-provincial trade prospers.11 Meng and Qu (2007) use inter-regional input-output tables in
1987 and 1997 to decompose industrial output growth in the two years. The authors find that
eastern and southern coastal regions are the most important destinations for industrial output of
central, northwestern, and southwestern regions, especially in the mining and manufacturing
industries. For example, they mention that about 40% of rail transportation capacity is used for
shipping coal across regions.
Foreign investors, who mainly enter the manufacturing sector, need energy, raw materials
and intermediate goods supplied by inland China.12 Hence, coastal foreign firms, to the extent
that they use domestic inputs, provide inland firms the opportunity to gain scale economies.
Foreign firms’ products also provide inputs to inland firms, offering the opportunity for
productivity gains through better intermediate and capital goods. As mentioned, firm level studies
suggest that the interaction between foreign firms and domestic firms exposes domestic firms to
advanced technology so FDI raises productivity through both backward and forward linkages.
These linkages imply that coastal FDI could contribute to economic growth of an inland city if the
city’s industries are sufficiently well developed to supply FDI abundant coastal provinces.
To formalize the link between coastal FDI and inland growth, I represent the real gross
output for a

n inland city as a function of local endowments:
, ,
 ,                                                                                                                     1
where Y is real GDP in an inland city and K , L, and F refer to the city’s domestic capital stock,
labor, and foreign capital stock, respectively. The technology parameter, A, is a Solow (1957)
total factor productivity index. Total differentiating (1), the growth rate of real GDP per capita

11 Young (2000) argues that there are increasing internal trade barriers in China. Holz (2009) reexamines evidence
for those barriers in Young (2000) and finds that no support for the argument. Rather, he argues that most recent
studies suggest decreasing local protectionism.
12 On average 64.6 % of FDI entered manufacturing during the period 1996 – 2004.
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