Institutions and international investments: Evidence from China and other emerging markets

Abstract

This thesis empirically investigates the underlying factors that explain the new global trade and investment patterns. At the baseline level, three questions on the globalization process of emerging markets are addressed. First, what is the causal linkage among institutions, external trade and foreign investment, and economic development? Second, given a limited number of emerging economies, how can we use regional differences within these countries to test theories of FDI? Third, what can we add to the FDI literature with discussion on a changing of the tides, in which an increasing share in global FDI originates from the developing world? After the introduction to the thesis and background theory, Chapter 2 of this thesis constructs a new measure to capture outsourcing trade and further tests the causal link between institutional quality and outsourcing using this new outsourcing proxy. One observation in this chapter is that institutions only affect outsourcing within lower-middle income countries. To explore the sources of endogenous institutions, Chapter 3 introduces a theoretical model in which institutions are shaped by incentives for local governments. Using regional data for China, this chapter also presents evidence that the differences in infrastructure across Chinese provinces are partly explained by the variation in local rents. Chapter 4 offers a novel method to first objectively define what institutions are and then to test their importance against the other determinants of trade and investment. Again based on Chinese data at the provincial level, there is evidence that infrastructure is a main driver of FDI inflows. Chapter 5 provides some insights into the motivations behind the newly arisen outward activities of China’s multinationals. It is implied that China’s dynamic institutional environment has a significant influence on the structural change of its outward FDI. The overall picture is that foreign companies enter developing countries for cost motives. This improves first ‘hard’- and then ‘soft’ institutions, and in turn allows some countries to upgrade to higher value added activities through outsourcing more and more complex tasks to them. In the chapters that deal with regional disparities within China, I find that initially low labor costs are of prime importance to attract FDI. To efficiently exploit low labor costs, local transportation and communication infrastructure then becomes important FDI determinant. For the more advanced regions, I find that institutional quality, such as rule of law and contract enforcement, has been increasingly crucial to attract FDI. Moreover, my analysis supports the following dynamics of external orientation of emerging markets. In a first stage, inward FDI and domestic production concentrates in labor intensive production which mainly results in exports. When export and the economy start growing, the first wave of outward foreign direct investments comes from the companies that are linked to the world economy as the ‘suppliers’ of these export industries. In the next phase, outward FDI follows exports to serve customers in important foreign markets. Global linkages and networks then leverage emerging firms to create their own competitive advantages, so as to move to more knowledge intensive production.