Local Institutions, Foreign Direct Investment and Productivity of Domestic Firms

• Author: Junjie Hong,Wei Huang,Xiaonan Sun
• Published date: 01 February 2016
• DOI: http://doi.org/10.1111/rode.12204
• Date: 01 February 2016

Local Institutions, Foreign Direct Investment and

Productivity of Domestic Firms

Junjie Hong, Xiaonan Sun, and Wei Huang*

Abstract

This paper examines the linkage between foreign direct investment (FDI) and the productivity of domestic

firms, paying particular attention to local institutions. Using Chinese manufactures from 1998 to 2007, we

find strong evidence that FDI negatively affects the productivity of domestic firms. Firm in regions with

better institutions suffers more from foreign presence owing to production contraction, labor cost increases

and innovation deterrence.

1. Introduction

As a share of world gross domestic product (GDP), both the flows and stock of

foreign direct investment (FDI) have increased significantly since the late 1980s. In

2009, China became the second most popular FDI destination (only behind the USA).

Holding the belief that FDI can generate positive externalities such as productivity

gains, technology transfer, introduction of management know-how, employee train-

ing, access to global distribution network, etc., policy makers around the globe

compete to ease the restrictions or offer special incentives to attract foreign enter-

prises.

However, empirical studies provide ambiguous evidence on the existence of hori-

zontal FDI spillovers, that is, positive effect of foreign investment in productivity of

domestic firms within the same industry. Some studies suggest significant spillover

effects in both developed and developing countries (Liu, 2008; Wei and Liu 2006)

while others cast doubt on the positive effects associated with foreign capital presence

(Aitken and Harrison, 1999; Keller and Yeaple, 2009; Branstetter, 2006). Since the

overall evidence on horizontal spillover is inconclusive, some economists suggest to

shift the debate to examining what are the factors that could direct the effects of FDI

on domestic firms (Meyer and Sinani, 2009). In order to answer this question, we have

to look into the mechanisms through which FDI could generate spillovers.

Previous studies illustrated mainly four channels of FDI spillovers: demonstration

effect, labor market turnover, technology transfer and access to international markets.

One of the primary conditions for these mechanisms to take effect is well founded

local institutions. According to Acemoglu and Johnson (2005), economic institutions

consist of institutions supporting private contracts and protecting private properties

from government or elite expropriation. In particular, factors such as law enforce-

ment and intellectual property rights (IPR) protection belong to the former institu-

* Hong: School of International Trade and Economics, University of International Business and Econom-

ics, 10 Huixing Dongjie Chaoyang District, Beijing, 100029 China. Tel: +86-(10)-6449-3393; Fax: +86-(10)-

6449-3042; E-mail: hongjunjie@uibe.edu.cn. Sun: Sauder School of Business, University of British

Columbia, Vancouver, BC V6T 1Z2, Canada. Huang: School of Insurance and Economics, University of

International Business and Economics, Beijing,100029 China.

© 2015 John Wiley & Sons Ltd

Review of Development Economics, 20(1), 25–38, 2016

DOI:10.1111/rode.12204