Competition for FDI: Is there a Diversion Effect?

FDI inflows have been a major driving force in development in East and South East Asia in recent years and some of the second tier NIEs, in particular have relied heavily on FDI for technology, management and marketing skills. The 'rise of PRC', in terms of its attraction of heavy FDI inflows, has caused considerable concern that if total FDI to the region is limited, PRC's gain will be at the expense of its neighbors. If as expected foreign firms have special advantages that allow access to export markets any FDI diversion will in turn have implications for trade flows and diversion effects. Insofar as South East Asian economies saw declining FDI inflows in the late 1990's in the aftermath of the regional Financial Crisis (and in the case of Indonesia net outflows), whilst PRC was the single largest developing country recipient, this concern had a superficial plausibility. However a closer examination of the data suggests the case is greatly overstated for a range of reasons.

First, there is often confusion in popular discussion between the absolute and relative size of FDI to PRC. Whilst in absolute terms FDI to PRC is very large, once this figure is compared with either population or some measure of economic activity in the country, the ratio is not an outlier in comparison with other countries. This is seen readily in the UNCTAD FDI Performance Index, which compares a country's share in global FDI to its share in global GDP. For 1999-2000 the figure for PRC at 1.2 is roughly the average for the region as a whole and is below the comparable figures for Singapore, Thailand and Malaysia (UNCTAD 2002, table 2.1).

Second, this type of comparison based on officially recorded FDI flows will give an upward bias to PRC's position, since it is widely accepted that 'round-tripping' – that is the export of domestically generated funds and its return to its country of origin as FDI, is more significant in PRC than elsewhere. The motives for round-tripping in the case of PRC are essentially threefold; the reinvestment of flight capital that may have had its origins in the black economy; the preference to register enterprises as foreign investment to take advantage of tax incentives not available to local firms; and the wish to incorporate companies abroad (particularly in Hong Kong, China) to take advantage of improved reputation, corporate governance and superior financial services. Xiao (2004) examines these issues in detail. Through a comparison of FDI statistics in the country of origin and PRC, he breaks down the discrepancy into what he terms a normal 'statistical error' and round-tripping. His most likely estimate of the latter is as high as 40% of FDI inflows in recent years (with high and low estimates of 50% and 30%, respectively). If recorded figures are adjusted downwards by this proportion, PRC's FDI Performance Index figures (as defined above) will appear well below the regional average.

A simple comparison of FDI statistics and their downward adjustment as appropriate casts some doubt on the extent to which FDI to PRC is unusually high. However, one can address the diversion argument more rigorously by identifying the explanatory factors behind regional FDI inflows and adding a separate variable for 'a PRC effect.' Chantasasawat et al (2003) do this by setting up a regression model that explains FDI to eight East and South East Asian economies (1985-2001) by a number of conventional variables (including measures of market size, tax rates, wage levels, human capital stock, infrastructure quality and government stability) plus FDI inflows to PRC.⁷ If the investment diversion case is valid one will expected a significant negative coefficient on the PRC FDI variable.

The key result of interest here is that when the level of FDI investment in the eight neighboring economies is examined, it is positively not negatively related to FDI in PRC. A 10% increase in FDI to PRC raises FDI in the region by 5%-6% depending on specification. Rather than finding evidence of FDI diversion, it appears that FDI creation is at work. The authors explain this by reference to production networking amongst international firms in the region, so that investment in PRC may be linked with investment elsewhere in the region to supply parts and components to plants located in PRC (or vice versa with PRC supplying parts and components to plants in one of the eight neighboring economies). This result holds whether or not FDI from Hong Kong, China, with an assumed high round-tripping element, is included in the analysis. The 'PRC effect' is not the strongest of the factors explaining FDI inflows with measures of trade openness and taxation showing higher elasticities. Nonetheless the significant positive sign on FDI to PRC is a strong undermining of the case that competition for FDI in the region is a zero-sum game. It seems preferable to view FDI flows as at least partially endogenous to regional activity, with FDI responding to the profit opportunities generated by regional growth and with FDI flows to one economy interacting positively with FDI flows to another as international firms exploit regional production sharing in a segmentation of the supply chain.

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