Productivity Gap and Inward FDI Spillovers: Theory and Evidence from China

• Published date: 01 March 2021
• Author: Jim Huangnan Shen,Hao Wang,Steve Chu‐Chia Lin
• Date: 01 March 2021
• DOI: http://doi.org/10.1111/cwe.12369

©2021 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 24–48, Vol. 29, No. 2, 2021

24

*Jim Huangnan Shen, Assistant Professor, School of Management, Fudan University, China and Center

for International Development, Harvard Kennedy School, US. Email: hnshen@fudan.edu.cn; Hao Wang

(corresponding author), Lecturer (Yunshan Scholar), School of Economics and Trade, Guangdong University

of Foreign Studies, China and School of Slavonic and East European Studies, University College London, UK.

Email: hao-wang@ucl.ac.uk; Steve Chu-Chia Lin, Professor, Department of Economics, National Chengchi

University, Taiwan, China. Email: cclin008@gmail.com.

Productivity Gap and Inward FDI Spillovers:

Theory and Evidence from China

Jim Huangnan Shen, Hao Wang, Steve Chu-Chia Lin*

Abstract

This paper constructs a two-stage sequential game model to shed light on the spillover

effect of inward FDI on the effi ciency of domestic fi rms in host countries. Our model

shows that, given an optimal joint-venture policy made by foreign firms, the impact

of the spillover effect of inward FDI is contingent upon the productivity gap between

the domestic firms and foreign ones. In particular, we demonstrate that the spillover

effect of inward FDI varies negatively with the productivity gap between domestic low-

productivity fi rms and foreign fi rms but works in the opposite way for high-productivity

firms. This suggests that once the productivity gap widens, the entry of foreign firms

will increase the effi ciency of high-productivity fi rms but reduce the effi ciency of low-

productivity firms. In support of our theoretical model, we provide robust empirical

results by using the dataset of annual survey of Chinese industrial enterprises.

Key words: effi ciency improvement, inward FDI, productivity gap, spillover effect

JEL codes: F21, L10, O40

I. Introduction

In recent decades there has been ongoing research on how far the spillover effect

of FDI contributes to the economic growth of host countries. Focusing on China,

the world’s largest emerging economy, some maintain that the dramatic growth and

the improved competitiveness of the domestic industrial capability of the Chinese

economy since the opening-up policy have been attributable to the massive scale

of inward FDI (e.g. Zhang, 2001; Yao, 2006; Lin et al., 2013; Chen and Wu, 2017).

Others, however, contend that the impact of FDI on local economic growth for the

©2021 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Productivity Gap and Inward FDI Spillovers 25

Chinese economy appears to be inconclusive (e.g. Lee and Chang, 2009; Buckley et al.,

2010). Indeed, as argued by Javorcik (2004), FDI can exert a positive spillover effect

on the local industrial enterprises if and only if the multinational firms form joint

ventures with domestic ones and are not fully owned foreign investments. Moreover,

Rodrik (1999) argues that a higher level of productivity in domestic fi rms producing for

export does not necessarily imply that they have received any technology spillover from

foreign fi rms, because most productive fi rms, whether domestic or foreign ones, tend to

specialize in their export sectors.

What sets the present paper apart from these works is that we provide a new angle

in terms of assessing the degree to which FDI could improve the productivity of local

industrial enterprises through the spillover effect. We demonstrate, with a theoretical

model, that, given an optimal joint-venture policy from foreign firms, the impact of

the spillover effect of inward FDI is contingent upon the productivity gap between the

domestic fi rms and foreign ones. In particular, we have found that the spillover effect

of inward FDI varies negatively with the productivity gap between low-productivity

domestic firms and foreign firms and the opposite holds true for high-productivity

domestic firms. Our results suggest that once the productivity gap widens, the entry

of foreign fi rms will increase the effi ciency of high-productivity fi rms and reduce the

effi ciency of low-productivity fi rms.

The contributions of this paper are twofold: theoretical and empirical. Although many

works that address the issues of FDI have documented robust evidence of its technology

spillovers to host countries (Blomstrom and Kokko, 1998; Sjoholm, 1999; Görg and

Greenaway, 2004), theoretical work illustrating the technology spillover effect of FDI

has been largely neglected in the literature. Baldwin et al. (2005) and Liu (2008) propose

a theoretical framework to study the spillover effect of FDI, but there are two apparent

weaknesses in their framework. First, both of their models are based on endogenous growth

theory, which does not manage to reveal the micro-mechanism, that is, the dynamics of

firm-level productivity improvement of such technology spillover from FDI. The only

thing that can be learned from their models is that the technology spillover from FDI leads

to long-run economic growth in host countries, and there is no role in these models for the

analysis of fi rm-level productivity dynamics. Second, due to the inability of these models

to describe fi rm-level productivity, there is obviously no role for the heterogeneous fi rm

framework in terms of analyzing the spillover effect in the host countries. The absence

of the heterogeneous fi rm framework easily leads to the misconception that technology

spillovers will always induce fi rms’ productivity in the host countries to improve and that

the anti-efficiency implications of the technology spillovers, such as the crowding-out

effect resulting from the entry of multinational fi rms, will be ignored.