Foreign Direct Investment and Economic Growth in China: Evidence from a Two-Sector Model

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IntroductionSince the implementation of economic reform and the open door policy in 1978, the Chinese economy has developed into a model of prosperity. China's infrastructure was improved, the commercial market was reactivated, and the Chinese people's living standard was greatly enhanced as a result. Furthermore, the Chinese economy has long been a driving force for the world's economic development. According to a recent Xinhua News report (2009)', from 1979 to 2008, China registered an annual growth rate of 9.8 per cent, 6.8 per cent higher than the world average; and its rate of contribution to the world economy rose from 2.3 per cent in 1978 to 14.5 per cent in 2006, second only to the U.S.A.This Chinese miracle was achieved along with China's market-oriented transition and integration into a global economy through a large influx of foreign capital. Chen, Chang, Zhang2 reviewed the role of foreign direct investment (FDI) in China's post-1978 economic development and found that FDI was positively associated with economic growth and the increase of total fixed asset investment in China. FDI also helped optimize the structure of export products, promoted employment, and forced an increasing number of domestic manufacturers to compete globally.While the opening of the Chinese economy to FDI is still an ongoing process, positive stimulating effects of FDI in China have been found to contribute toward the success of its recent economic reform. The main purpose of this paper is to analyze the interrelation between foreign direct investment and economic growth in terms of inter-sectoral externalities. Specifically, we intend to :* investigate whether there are externalities between the domestic-funded sector and the foreign-funded sector of the Chinese economy, and* estimate the magnitude of externalities, if any.In this paper, the foreign-funded sector is composed of foreign-capital enterprises, referring to enterprises established in China by foreign investors, exclusive with their own capital, which also include Hong Kong, Macao- and Taiwan-invested enterprises. Branches set up in China by foreign enterprises are excluded. In contrast, the domestic-funded sector consists of all enterprises excluding foreign-capital enterprises.To set up the analytical framework, we adopt the two-sector model popularized by Feder3. In his seminal work that analyzed the relation between export performance and economic growth, Feder2 divided the economy into two sectors: the export sector and the nonexport sector. He then formulated separate production functions for both sectors to evaluate the impact of export on economic growth. Several subsequent studies extended Feder's model by dividing the economy into government and non-government sectors (Ram4), financial and real sectors (Wang and Yu5), and defense and civilian sectors (Biswas and Ram6; and Atesoglu and Mueller7), respectively. Following Feder, we derive two empirically testable models, foreign investment supply-guided model and domestic investment demanddriven model, that link economic growth with sectoral labor forces and capital stocks. We then use panel data from 1993 to 2007 to test both models.PreludeThe research on the impact of FDI on the host country can be divided into two camps with opposing viewpoints. One group of studies argues that foreign technology, human resources and management concept have a positive impact on the host country. For instance, Abramovitz8 and Maddison9 found that the greatest advantage late-comers have in economic development vis-a-vis front-runners is the technological gap between them. Late-comers can increase productivity by adopting advanced technology so that they can catch up with the front-runners. Barro and Sala-i-Martin10 analyzed technical progress, technological gap and spillover, human resources and other factors that influence economic growth. They also established a model to show the relationship among these factors, which provides a foundation for later research on the relation between international investment and economic growth. …