Is China on the investment development path?

• Author: Marton, Katherin
• Position: Report

ABSTRACT

The paper investigates the relationship between China's net direct foreign investment position and economic development and the investment development path (IDP) theory introduced by Dunning (1981). Using annual data for the period 1979 to 2005 and a fourth order single variable polynomial function we demonstrate that form of the IDP for China and conclude that China entered stage 3 of the path postulated by the IDP theory. by analyzing key factors which have impacted FDI inflows and outflows we find that certain idiosyncratic characteristics of Chinese companies and institutional factors may limit the significant increase in the multinationalization of Chinese firms which would be required for the country to move along the IDP.

Keywords: Equity Rights Offers, Economic Effect, Capitalization Effect, Rights In Developing Markets

INTRODUCTION

As the major phenomenon of the global economy China's dramatic economic growth and reforms of the past two decades have been studied extensively. This rapid transformation has taken place under state and local government control and direction and has created new economic institutions and enterprise forms under a system of market socialism. Drawing on the experience of 'late-comers' and the sheer size of its market China has benefited greatly from foreign direct investment inflows. It has become the developing countries largest and the world second largest recipient of such flows. This paper seeks to contribute to the understanding of the relationship between the economic development of China and foreign direct investment. We use the framework of the Investment Development Path (IDP) theory which establishes a dynamic relationship between these two variables and identifies the stages through which countries progress. While the IDP measures the performance of the country on a macro level, it is based on the structural transformation of companies and their competitiveness. By applying this theory to China we hope that the findings of this study will contribute to a better understanding of China's particular nature of economic development, and the integration of its firms in the global economy.

The first section of the paper reviews the theory of IDP and selected studies that previously examined this theory. In the second section, we test the theory for China and present our findings. We follow with a discussion of the variables that influence FDI flows to China. We conclude this study by putting forward some propositions about development of China's future net investment position.

THE INVESTMENT DEVELOPMENT PATH MODEL

The Investment Development Path (IDP) theory hypothesizes that there is a relationship between a country's net foreign direct investment and its level of economic development. The premise of the theory is twofold: it perceives economic development as a process of structural change (such as progressive improvement in the country's technological and productive system); and this structural change influences the pattern of both inward and outward foreign direct investment and, thus, the country's net outward investment position (NOIP) (Dunning, 1981). As postulated by the eclectic theory of foreign direct investment, the dynamic relationship between economic development and NOIP is attributed to the changes of ownership, location and internalization (OLI) advantages (Dunning, 1988). In the stylized form of the IDP theory, countries progress through five stages. This progress takes place in response to the changing conditions of the country's location-specific advantages, and, thus, its attractiveness to foreign investors, on the one hand, and its gradual upgrading of domestic firms' ownership specific advantages on the other (Dunning 1981, Dunning 1986). The first stage characterizes pre-industrial societies where weak local demand and inadequate infrastructure limit the attractiveness of the country to foreign investors while domestic companies lack the requisite ownership-specific advantage of invest abroad. As the government initiates basic infrastructure development and local demand grows, foreign investment flows are initiated and directed predominantly to consumer goods production. During the second stage a significant increase in the inflow of FDI takes place and its growth rate surpasses that of the GDP. At this stage, the ownership specific advantages of domestic companies are weak and this limits their outward investments. To the extent firms do invest abroad, it is in response to the local government's "push," for example in response to subsidies granted for export supporting investment and or capital allocation for resource acquisition (Dunning, 1988). During stage 2 the net investment position of the country is negative and has a decreasing trend.

Stage 3 is characterized by a gradual decrease in the rate of growth of inward investment flows. This decrease is largely due to the growing competitiveness of local firms vis-a-vis foreign companies. Domestic firms also increase their outward investment due to the improvement of ownership specific advantages. The FDI outflow will be directed initially to resource seeking investments in order to support domestic development and increasingly to market oriented investments. With the exception of technology-intensive sectors, the ownership specific advantages of domestic companies will be similar to companies based in advanced countries. At the third stage the rate of FDI outflow surpasses the rate of FDI inflow, even though the cumulative value of inward FDI stock still exceeds that of outward FDI stock. The country's NIOP is still negative but is on an upward trend. The country enters stage 4 when the outward FDI stock exceeds inward FDI stock and the rate of outward foreign investment increases faster than the rate of inward investment. Ultimately, at stage 5, the net investment position will tend to oscillate around 0, with temporary negative or positive figures, largely influenced by prevailing macroeconomic conditions such as foreign exchange valuations and the business cycle. Most advanced countries are at this stage (Dunning and Nerula, 1994).

It is not assumed that this stylized IDP is normative or characterizes all countries (Dunning and Narula, 1996). Country-specific variables that influence firm-specific advantages, such as size of the market, structure of the economy, resource endowments, and particularly the role of government, can create IDP relationships which differ from the average. Nor does the IDP theory assume predictive power or that once a country departs from the average pattern it will necessarily return to it. It also assumes that the variables of the eclectic theory, which is the cornerstone of IDP, are influencing ownership specific advantages differently in developing and developed countries. Companies that are based in advanced countries derive competitive advantage through internalizing their foreign activities which then reduce their transaction costs. Companies from developing countries tend to derive their ownership advantages from their home country's factor endowments, such as low labor costs (Dunning 1988; Lall 1998). These differences in sources of ownership advantages may result in differences in the outward investment pattern of the countries.

Dunning (1981) tested the IDP theory by using cross sectional data for 67 countries for the period 1967-1975. Using average values for the time period, he found that once a country reached a "threshold" level of per capita GDP, both inflow and outflow of FDI start to increase. As postulated by the 5-stages model, the NOIP of the country starts out at zero, declines through stage 2 and increases through stages 3 and 4, and returns to zero in stage 5. Therefore, the IDP follows a U or J shape which can be expressed as a quadratic function. Dunning (1981) divided the sample countries into groups, representing each stage of development along this U shaped path.

During the past two decades, the IDP was tested on various groups of countries, using both cross-sectional and longitudinal data, as well as on an individual country level, with different results. Using FDI flow data for 30 countries Tolentino (1993) found a close relationship between NOIP and GDP per capita for sub-periods but not for longer periods. For the sample of countries she used the relationship between the level of development and NOIP was specified by an inverted L shape rather than a U or J shaped relationship of the IDP. FDI stock data for 40 countries used by Narula (1999) for the period 1980-1992 confirmed the J shaped relationship between NOIP and GDP per capita. (He attributed Tolentino's findings to methodological problems). Applying the IDP model to 18 industrialized countries Pichl (1989) found that outward FDI stock was closely associated with the level of economic development while this was not the case for FDI inflow.

Several studies were conducted on an individual country level using time series data. Most of these findings indicated a good explanatory power for the IDP model, albeit with variations from the assumed functional specification. Among the more recent cases is the study of Portugal for 1943-1998 (Buckley and Castro, 1998). They found for the period studied that there was a close relationship between per capital GDP and NOIP but that a polynomial function expressed the relationship better than the quadratic function assumed by IDP. Research on Austria, a small advanced open economy, concluded that for the 1980-1998 period Austria's NOIP did not confirm to the IDP. With economic development the country's NOIP decreased (Bellak, 2001). However, on a micro level using industry-level data and on a bilateral country level (Austria-Germany) the explanatory power of IDP improved significantly.

Duran and Ubeda (2001) note the limitations of using cross-sectional data as the input for the IDP model. They argue that the cornerstone...