Santa Cruz Center for International Economics

China in recent years has emerged as the largest recipient of foreign direct investment (FDI) in the world. Many analysts and government officials in the developing world have increasingly expressed concerns that they are losing competitiveness to China. Is China diverting FDI from other developing countries?

Theoretically, a growing China can add to other countries’ direct investment by creating more opportunities for production networking and raising the need for raw materials and resources. At the same time, the extremely low Chinese labor costs may lure multinationals away from sites in other developing countries when the foreign corporations consider alternative locations for low-cost export platforms.

In this paper, we explore this important research and policy issue empirically. We focus our studies on East and Southeast Asia as well as Latin America. For Asia, we use data for eight Asian economies (Hong Kong, Taiwan, Republic of Korea, Singapore, Malaysia, Philippines, Indonesia and Thailand) for 1985-2002 while for Latin America, we use data for sixteen Latin American economies (Argentina, Bolivia, Brazil, Chile, Columbia, Costa Rica, Ecuador, El Salvador, Guatemala, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay and Venezuela) for 1990-2002. We control for the standard determinants of their inward direct investment. We then add China’s inward foreign direct investment as an indicator of the “China Effect”. Estimation of the coefficient associated with the China Effect proxy gives us indications about the existence of the China Effect.

We have three results: (1) The level of China’s foreign direct investment is positively related to the levels of inward direct investments of economies in East and Southeast Asia, while the China Effect is mostly insignificant for Latin American nations; (2) the level of China’s foreign direct investment is negatively related to the direct investment of these economies as shares of total foreign direct investments in the developing countries; (3) The China Effect is generally not the most important determinant of the inward direct investments of these economies. Market sizes and policy variables such as openness and corporate tax rates tend to be more important.