Foreign direct investment and inequality: Evidence from China's policy change

• Date: 01 June 2020
• Author: Anders C. Johansson,Dan Liu
• Published date: 01 June 2020
• DOI: http://doi.org/10.1111/twec.12901

World Econ. 2020;43:1647–1664. wileyonlinelibrary.com/journal/twec

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1647

© 2019 John Wiley & Sons Ltd

Received: 10 September 2018

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Revised: 5 August 2019

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Accepted: 2 November 2019

DOI: 10.1111/twec.12901

ORIGINAL ARTICLE

Foreign direct investment and inequality: Evidence

from China's policy change

Anders C.Johansson1

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DanLiu2

1Stockholm School of Economics, Stockholm, Sweden

2Faculty of Economics and Management, East China Normal University, Shanghai, China

Funding information

Dan Liu is thankful for financial support from the National Natural Science Foundation of China, project No. 71703187.

KEYWORDS

China, foreign direct investment, inequality, skill premium

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INTRODUCTION

It has been over three decades since the People's Republic of China (PRC) implemented its economic

reforms and opening-up policy. Figure 1 shows that there is a strikingly increasing trend in FDI in-

flows since the 1980s. Especially after China joined theWTO in 2000, the speed of this increase has

remained stably high. In 2012, China surpassed the United States for the first time to become the

world's largest recipient of global foreign direct investment.1 Undoubtedly, foreign direct investments

have played an important role in China's economic development. At the same time, overall inequality

has been increasing in China, with a Gini coefficient around 0.3 in the early 1980s and as high as 0.47

in 2012.2 There are a number of studies on the connection between FDI and inequality (e.g., Goldberg

& Pavcnik, 2007), but most of them focus on the potential contribution of FDI to regional develop-

ment and thus interregional inequality (Lessmann, 2013; Wan, Lu, & Chen, 2007; Yang, 2002). Little

attention has been paid to how FDI can affect the local labour market and local inequality, which is the

main focus of this paper.

In this study, we investigate the effect of FDI liberalisation on within-city inequality. This is an

important issue for several reasons. First, within-city inequality is a vital aspect of overall inequality.

In the census data, within-city inequality accounts for about 78% of the overall inequality in China.3

The most recent literature on urban economics has documented that the rising inequality in big cities

has contributed significantly to the increase in overall inequality in the US (Baum-Snow & Pavan,

1 This refers to the FDI inflows to mainland China and Hong Kong in 2012. The data come from the World Investment Report

2016 published by the United Nations.

2 See Gustafsson, Li, and Sicular (2008) and Wan, Ye, and Zhuang (2012) for more information.

3 Urban Household Surveys show that the proportion of inequality accounted by the within-city component has increased

from 74% in 1992 to 81% in 2009 (Chen et al, 2018).

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JOHANSSON ANd LIU

2013). Second, recent studies have shown that within-city comparison is more closely related to peo-

ple's happiness (Jiang, Lu, & Sato, 2012; Knight,Song, & Gunatilaka., 2009). This implies that un-

derstanding how FDI is connected to local inequality has important welfare implications. Moreover,

by focusing on city-level urban inequality, we can avoid the potential measurement issue of interre-

gional inequality discussed by Li and Gibson (2013). Finally, as the urbanisation process progresses

over time in China, the policy relevance of analysing urban inequality should become increasingly

relevant. To the best of our knowledge, this paper is the first attempt to examine how local urban in-

equality can be affected by FDI policy change.

As widely documented in the literature, it is extremely challenging to establish causality on this

issue due to the endogenous location choice of FDI inflows. Local characteristics, such as market size,

infrastructure, wage and education, can be closely related to the degree of inequality and at the same

time affect the location pattern of FDI firms (Cheng & Kwan, 2000). In this paper, we take advantage

of the national policy change on FDI at industry level, which is reasonably exogenous at city level.

Cities experienced various degree of policy shocks due to their existing industrial compositions.

We first construct the measure of local FDI liberalisation following a methodology that is simi-

lar to what has been adopted to investigate the impact of tariff cuts on local labour markets (Autor,

Dorn, & Hanson, 2013; Dai, Huang, & Zhang, 2018). We then link this policy shock to various city

inequality measures, which are calculated using individual information from the 2005 mini census.

We find a strong and positive association between FDI liberalisation and within-city Theil index.

Moreover, it is found that this connection is mainly caused by the significant impact of FDI liberalisa-

tion on between-skill-group inequalities. As a next step, we therefore focus on establishing the causal

relationship between FDI liberalisation and college premium, which is a widely adopted measure of

between-skill-group inequalities. After dealing with the potential biases caused by missing variables

and simultaneity, we find a robust and positive impact of FDI liberalisation on the local skill premium.

Next, we explore the potential mechanisms from both firm and individual aspects. Our attention

is restricted to three channels: wage effect, composition effect and spillover effect. First, we compare

FIGURE 1 Foreign direct investment in China, flows ($, million).

Source: China Statistical Yearbook (1984–2012), National Bureau of Statistics of China [Colour figure can be viewed

at wileyonlinelibrary.com]

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