Distinguishing the Complex Effects of Foreign Direct Investment on Environmental Pollution: Evidence from China.

AuthorChen, Jianxun
  1. INTRODUCTION

Over the last two decades, emerging economies have been among the largest recipients of foreign direct investment (FDI) in the world (Kudina and Pitelis, 2014; Majumdar and Kar, 2017). To maintain or strengthen their competitiveness, some emerging countries have lowered environmental standards to attract FDI (Antoci et al., 2015; Dean et al., 2009; Markusen et al., 1995). In addition to the increased inflow of FDI, some pollution-intensive industries have relocated to these countries as well (Candau and Dienesch, 2017; Ljungwall and Linde-Rahr, 2005; Zugravu-Soilita, 2017). Consequently, scholars have observed that environmental quality in many emerging countries has declined as a result of more FDI inflow (Albrecht, 1998; Hettige et al., 2000).

This phenomenon raises the question of the relationship between FDI inflow and environmental pollution (Christmann, 2001; Costa-Campi et al., 2018; Hirsch et al., 2020; Rezza, 2013), particularly in emerging economies reflecting rapid industrialization. How does FDI impact environmental pollution in these emerging countries? The literature reveals two contrasting arguments. One argument contends that emerging countries receive FDI as many multinational enterprises (MNEs) relocate in response to stringent environmental legislation in the MNEs' home countries (Ljungwall and Linde-Rahr, 2005). The other argument contends that FDI inflow can improve environmental quality, as more advanced technologies from MNEs enable emerging countries to cope with environmental issues effectively (Jensen and Mina, 2019; Ning and Wang, 2018).

Beyond these two opposing arguments, some scholars have suggested that the mechanism through which FDI affects environmental pollution is complex (Grossman and Krueger, 1991; Selden and Song, 1994). For instance, He (2006) found that the negative effect of FDI on economic growth offsets its positive effect originating from technological innovation and strict environmental regulations. Sheng and Lv (2012) further categorized the total effect of FDI on environmental pollution into three mechanisms: the scale effect, structure effect (also called the composition effect), and technology effect. (1) The combinations and changes among these three effects result in a complex relationship between FDI and environmental pollution.

Although these three mechanisms help explain the complex effect of FDI on environmental pollution, two gaps remain that require further investigation. First, most previous studies focus mainly on the effect of FDI on overall environmental pollution by either considering only one type of pollutant or considering all pollutants as a whole, overlooking the differences between various pollutants. Given that different pollutants are regulated by different government departments, disparities exist in the regulation and management of environmental protection. Thus, exploring only one type of pollutant or simply lumping the pollutants into a whole will blur such differences. Insight from He (2006) suggested that FDI has a positive impact on some pollutants and a negative impact on others. Therefore, our first research question is: how does FDI impact different types of environmental pollution?

Second, the literature reveals a static perspective of the FDI's effect on environmental pollution (Grossman and Krueger, 1991; Selden and Song, 1994), hence neglecting the dynamic change in this effect over time. However, time is crucial for two reasons. On one hand, MNEs require time to set up factories, produce and discharge emissions in host countries (Omri et al., 2014), and local firms also need time to absorb environmentally friendly technology obtained from MNEs (Lovely and Popp, 2011). On the other hand, the revision and adjustment times of environmental protection policies can also change the effect of FDI on environmental pollution, because differences might exist before or after the adjustment time. Hence, our second research question for this study is: when does the effect of FDI on environmental pollution vary with the policy revision time?

By addressing these two questions, this study attempts to extend the literature on the relationship between FDI and environmental pollution in the following ways. First, we distinguish the effect of FDI on the three types of environmental pollution, in contrast to prior research emphasizing one type of pollutant or simply lumping together various pollutants. We classify environmental pollution into three types: air pollution, water pollution, and solid (waste) pollution, given that they require different governance and control mechanisms. Therefore, the classification of pollutants can clarify the variant effects of FDI on different environmental pollutions and reconcile the inconsistent findings in the literature.

Second, although scholars have established that the impact of FDI on environmental pollution can be broken down into the scale effect, structure effect, and technology effect (Bao et al., 2011; Liobikiene and Butkus, 2019; Sheng and Lv, 2012), the literature does not differentiate these effects regarding different types of environmental pollution. This study compares the differences in FDI's scale effect, structure effect, and technology effect on the three types of environmental pollution, thereby deepening our understanding of how FDI affects specific type of environmental pollution via complex mechanisms.

Third, unlike the static view of the relationship between FDI and environmental pollution (Bakhsh et al., 2017), this study compares FDI's changing effects on environmental pollution by considering the time effect. The implementation and adjustment of a host country's environmental protection policy affects the choice of FDI and pollution emissions (Kirkpatrick and Bennear, 2014; Vatn, 2020; Wang and Chen, 2014). Overlooking the time effect makes it difficult to understand the dynamic changes and evolving process of FDI on environmental pollution (and Nahrath, 2020; Karplus and Zhang, 2017; Zhang and Qin, 2016). This study compares the changes in FDI's effect on environmental pollution before and after the environmental policy adjustment time, thus enriching our understanding of when FDI impacts environmental pollution differently in response to policy revision changes over time.

(2.) LITERATURE REVIEW AND HYPOTHESES

2.1 Literature review

How does the inflow of FDI impact environmental pollution in host countries? Two opposing views and arguments emerge: the pollution haven argument and the pollution halo argument. The pollution haven argument derives from McGuire (1982), Pethig (1976), and Walter and Ugelow (1979), who investigated the effect of environmental regulation on FDI's industrial transfer. They argued that in order to reduce the costs associated with higher environmental protection regulations in home countries, firms in developed countries preferred to transfer, via FDI, polluting or sunset industries to developing countries, where environmental regulation standards were relatively low (Xing and Kolstad, 2002). Such transfer worsened environmental quality in developing countries (Hubler and Keller, 2010). Grounded in this perspective, some scholars further proposed the "racing to the bottom" hypothesis (Wheeler, 2001), contending that developing countries, to attract FDI, would compete to lower environmental standards. To maintain competitive advantage, firms in developed countries might transfer production to developing countries where environmental costs are lower due to loose regulation standards. Hence, developing countries attract FDI by decreasing environmental regulation, resulting in environmental deterioration in these countries (Esty and Geradin, 1997; Wheeler, 2001). Consequently, the competitive behavior of attracting FDI by loosening environmental regulations in developing countries might lead to the collapse of environmental standards (Olney, 2013).

Some empirical studies have found evidence to support the pollution haven argument, particularly the idea that the cost of environmental regulation with stricter standards was higher in high-income countries than that in low-income countries (Jaffe et al., 1995; Mani and Wheeler, 1998). Thus, low-income countries have a comparative cost advantage deriving from relatively lax environmental standards. The literature also indicates that MNEs in high-pollution industries have an embedded motivation to relocate the production base from high-income to low-income countries, to exploit such cost advantages (Spatareanu, 2007). Mani and Wheeler (1998) revealed that in the 1970s, environmental regulation among OECD members was strict, while developing countries did not care to raise environmental standards. Adopting panel data of six pollution-intensive industries during 1995 and 2002, Wagner and Timmins (2009) found that the pollution haven hypothesis was supported in many pollution-intensive industries.

However, other scholars have found evidence that the pollution haven hypothesis was not solid (Friedman, Gerlowski and Silberman, 1992) or even invalid (Javorcik and Wei, 2004), and that the "racing to the bottom" model had no empirical support (Dasgupta et al., 2001; Wheeler 2001). Some findings revealed that pollution control or its associated cost was not the critical factor affecting the industrial transfer of MNEs (Albrecht, 1998; Eskeland and Harrison, 2003; Tobey, 1990;). Rather, the major factors were taxation, domestic markets, and foreign exchange restrictions (Esty and Geradin, 1997; Oetzel and Doh, 2009). In other words, these findings did not support the pollution haven hypothesis.

Moreover, ample empirical evidence demonstrated that FDI inflow positively affected environmental quality because of an environment-friendly technology spillover effect on local firms, which is called the pollution halo effect. Warhurst (1999) examined FDI's positive effect on clean technology transfer...

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