Bilateral Rent-Seeking and Growth of FDI Inflow in China: Theory and Evidence

Abstract

This paper proposes a new theory so called bilateral rent-seeking to explain the dramatic growth of foreign direct investment (FDI) inflow in China in the past several decades. We construct a Nash bargaining model to illustrate the relevance of how the reciprocal relationship between the local state and foreign investor leads to the enlarged incentives for the later to invest in the local market. It is argued that the conventional one-way channel through which the foreign firms pays the rent-seeking fees to local government to get access to the licenses to operate in the local market could not fully explain the rise of FDI. The local government’ provision of subsidies to foreign firms as another channel must be taken into account in terms of elucidating the rationale of huge FDI inflows in China. Our result shows that the higher level of rent-seeking fees paid by foreign firms would lead to the increase in the subsidy level provided by the local government, which in turn further encourages the foreign firms to invest in the local market. We also find that given the subsidies level provided by the local government is larger than the rent-seeking fees paid by the foreign firms, both escalating level of rent-seeking fees and local government’s subsidies would lead to the higher output of foreign firms if and only if the foreign firm’s bargaining power is neither too high nor too low. This indicates that bilateral rent-seeking activities could contribute to the local economic growth as long as the division of bargaining power between foreign firms and local government tends to be more symmetrical. The empirical evidences presented in the end are broadly consistent with the theories proposed in this paper. .