Related Literature

One branch of related literature has sought to explain possible relationships between international trade and FDI. The traditional Heckscher-Ohlin (H-O) theorem of trade helps in explaining the PRC's trade pattern. With the largest population in the world and relatively low wages, the PRC has comparative and even absolute advantage in manufacturing laborintensive products relative to most of its trading partners. As the PRC has increasingly integrated into the world economy over the past three decades, it has evolved into a major exporter in most categories of labor-intensive goods, as predicted by the H-O theorem. Based on the same H-O framework, early theoretical analyses also predict product trade and international capital movements act as substitutes (Mundell 1957). This framework indicates an increase in a country's inward FDI flows will dampen its trade growth.

More recent theories that incorporate multinational enterprise production into models of international trade develop two different hypotheses to explain the relationship between FDI and trade flows. In vertical integration models such as Helpman (1984), the primary incentive for FDI is to seek lower production costs in the host country and then to export goods produced or processed by the firm's foreign affiliates. This type of FDI inflow will increase a host country's trade, primarily through increased exports.² On the other hand, a host country's trade is predicted to decrease in horizontal integration models (Horstmann and Markusen 1992) where FDI inflows substitute for imports. In this case, firms move the production of their exportable products to the host country to economize on firm-level economies of scale, avoid trade barriers, and reduce transportation costs.

Gu, Awokuse, and Yuan (2008) and Xing (2007) examine the recent relationship between trade and FDI for the PRC. Gu, Awokuse, and Yuan (2008) use disaggregated manufacturing sector data for 1995–2005 to conclude that the PRC's FDI inflows have statistically significant and positive effects on the PRC's total exports, but these effects differ across industries. With trade data from 1980 to 2004, Xing (2007) investigates to what extent FDI promoted intra-industry trade between the PRC and its major trading partners; Japan and the US. The analysis indicates that Japanese direct investment in the PRC performed a significant role in enhancing intra-industry trade between Japan and the PRC. However, there is no such evidence found for the US direct investment in the PRC. Therefore, the effect of inward FDI on the PRC's economy can be different for different industries and source countries.

Another branch of the literature has produced descriptive analyses focused typically on a particular bilateral relationship or on a particular country's international linkages. For example, Branstetter and Foley (2007) provide an example of the former, with a focus on PRC-US FDI linkages.³ They attempt to debunk several misconceptions regarding US investment in the PRC by pointing out that US FDI in the PRC is not large, is not very exportoriented, does not replace investment elsewhere, and does not exploit increased technology levels in the PRC. The Japan-PRC relationship is examined in research such as Cassidy and Andreosso-O'Callaghan (2006), which identifies spatial determinants of Japan's FDI in the PRC.

Lipsey (2000) differs from the previously mentioned literature by focusing on the activities of US and Japanese manufacturing affiliates in East Asia rather than on FDI flows. He finds that US affiliates in East Asia were more export-oriented than were Japanese affiliates in East Asia in 1977, but that the US affiliates became less export-oriented over time while the Japanese affiliates became more export-oriented up to 1995. Since Lipsey's study used data from 1977 as a starting point, the focus of his study was on the four so-called newly industrializing economies—Hong Kong, China, the Republic of Korea, Singapore, and Taipei,China—and four members of the Association of South East Asian Nations (ASEAN)— Indonesia, Malaysia, the Philippines, and Thailand. His results for American and Japanese affiliates located in these other East Asian economics will be compared with our results for affiliates in the PRC later in this paper.

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