Japanese FDI in China: Determinants and Performance

Abstract

Japanese foreign direct investment (FDI) into China is an important aspect of one of the largest bilateral economic relationships in the world. The bilateral FDI is analysed using an FDI model combined with stochastic frontier analysis to explain the determinants of FDI, measure the performance of FDI using the frontier, and to measure all unobservable or difficult to measure barriers to investment. The FDI frontier is estimated using core determinants and a second stage of the modelling allows for explaining some of the barriers that FDI face. The choice of variables for both stages is made clear using a model derived from theory and on multinational enterprise behaviour. Both stages allow for an overlap of two important yet independent streams of FDI literature. The analysis allows for the inclusion of a measure of political closeness between countries which is another innovation in the analysis of FDI flow. The influence of politics and other barriers (or resistances) on a FDI relationship can best be understood in the context of the other determinants of investment flows. Political closeness between countries is shown to affect FDI. An improvement in political relations is associated with an increase in FDI by reducing uncertainty in the investment environment. The performance of Japanese FDI into China is shown to be high relative to its potential since 1986, the year China started its negotiations to join the GATT in 1986. That year saw a policy shift in China which opened many doors for foreign firms to enter and operate in China. Japanese FDI performance in China was high from 1986 until the Asian financial crisis in 1997/98, including through Chinese domestic political turbulence in 1989. Japanese FDI faces less resistance in China than any other major investing source and since WTO entry has bounced back from the post Asian financial crisis slump to be at the level predicted by the average performance worldwide after accounting for the determinants of FDI. Chinas WTO accession in 2001 helped reduce uncertainty and gave confidence in bilateral investment, with the effect of mitigating the effects of increased uncertainty from rising bilateral political tensions after 2001.