Journal of Asian Economics 16 (2005) 719736

China and India: Any difference in their FDI performances?

Wenhui Wei *
Institute for Health, Health Care Policy, and Aging Research & Department of Economics, 30 College Avenue, Rutgers, The State University of New Jersey, New Brunswick, NJ 08901-1248, USA Received 15 January 2005; received in revised form 25 May 2005; accepted 1 June 2005

Abstract This study aims to explore the determinants of inward FDI in China and India and the causes for their huge difference. I rst used random-effect models to analyze separately the determinants of FDI from OECD countries in China and India, and then applied the Oaxaca-Blinder decomposition to examine the causes of the differences. It was found that Chinas much higher FDI from OECD countries was mainly due to its larger domestic market and higher international trade ties with OECD countries. India, however, had advantage in its cheaper labor cost, lower country risk, geographic closeness to OECD countries, and cultural similarity. # 2005 Elsevier Inc. All rights reserved.
JEL classication: F21 Keywords: Foreign direct investment

1. Introduction China and India, as the two largest developing countries in the world, have been both enjoying fast economic growth since the 1980s. China seems to be performing better
The ndings and opinions reported here are those of the author and do not necessarily represent the views of any other individuals or organizations. This work was partially based on Wenhui Weis Ph.D. dissertation titled Foreign direct investment in China. * Tel.: +1 732 932 0365; fax: +1 732 932 6872. E-mail address: wwh@rci.rutgers.edu.

1049-0078/$ see front matter # 2005 Elsevier Inc. All rights reserved. doi:10.1016/j.asieco.2005.06.004

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Table 1 Key economic indicators for China and India Year GDP China 1980 1985 1990 1995 2000 2002 163,617 272,301 397,635 700,278 1,041,218 1,208,854 India 156,938 203,771 275,604 355,163 470,313 517,263 GDP per capita China 167 259 350 581 825 944 India 228 266 324 381 463 493 Export China 50,869 69,927 88,295 167,974 330,374 468,691 India 12,046 12,671 20,110 39,083 67,284 87,757 Import China 29,290 62,510 59,150 151,882 268,624 379,489 India 10,631 14,375 19,089 43,334 65,884 74,044

Note: GDP, Export and Import are in 1995 constant millions US dollars. GDP Per capita is in 1995 constant US dollar. Source: 2003 World Development Indicators.

(Table 1). In 1980, China was at par with India in GDP, yet 30% lower in its GDP per capita ($168 versus $266). Twenty-two years later, Chinas GDP was well over twice of Indias and its GDP per capita also increased to $944, almost twice that of India. From 1980 to 2002, Chinas average GDP growth rate was 9.5%; for India, this gure was not bad either, but only about 5.6%. Whats more phenomenal, however, is the difference in their FDI performance (Table 2). The ofcial statistics showed that China reported FDI net inows from a mere $0.4 billion in 1990 to $52.7 billion in 2002. Those to India increased from $0.07 billion to $2.6 billion during the same time period. Since the early 1990s, annual FDI inow into China was at least 3.6% of its GDP, and 10% of its gross capital formation. For India, however, the gures never exceeded 1 and 4% respectively. China ranked 54th and India 122nd in 19992001 in the FDI Performance Index by UNCTAD, which is measured by the ratio of a countrys share in global FDI ows to its share on global GDP (UNCTAD, 2004). China ranked 1st in 2002 and 2003 (India 15th in 2002 and 6th in 2003) in the FDI Condence Index, which is based on surveys of executives at the worlds 1000 biggest companies that contribute about 70% of FDI ows and generates $18 trillion in annual sales (2002; A.T. Kearney, 2003). According to World Investment Report 2003 (UNCTAD, 2003), FDI also helps driving Chinas economic growth. FDI, it nds, has contributed to the rapid growth of Chinas merchandise exports at an annual rate of 15% between 1989 and 2001. In 1989 foreign afliates account for less than 9% of total Chinese exports, but by 2002 they provided half. In some high-tech industries in 2000, the share of foreign afliates in total exports was as high as 91% in electronic circuits and 96 per cent in mobile phones. About two-thirds of FDI ows to China went to the manufacturing sector in 2002001. In India, by contrast, FDI has been much less important in driving export growth except in information technology. Sharma (2003) found that foreign investment appears to have statistically no signicant impact on export performance although its coefcient has a positive sign. FDI in Indian manufacturing has been and remains domestic market seeking. FDI accounted for only 3% of Indias export in early 1990s and even today, it is estimated to account for less than 10% of Indias manufacturing exports. For China, the report says, its share of FDI inows in 20002001 went to a broad range of manufacturing industries. For India, most went to services, electronic and computer industries.

W. Wei / Journal of Asian Economics 16 (2005) 719736 Table 2 FDI Inows to China and India Year FDI net inow (Bop, current Million US$) China 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 430 636 1258 1659 1875 2314 3194 3393 3487 4366 11,156 27,515 33,787 35,849 40,180 44,237 43,751 38,753 38,399 44,240 India 79 92 72 6 19 106 118 212 91 252 162 74 277 550 973 2144 2426 3577 2635 2169 2315 3403 % of GDP China 0.2 0.3 0.5 0.5 0.6 0.9 1.0 1.0 1.0 1.2 2.7 6.4 6.2 5.1 4.9 4.9 4.6 3.9 3.6 3.8 India 0.0 0.1 0.0 0.0 0.0 0.1 0.1 0.1 0.0 0.1 0.1 0.0 0.1 0.2 0.3 0.6 0.6 0.9 0.6 0.5 0.5 0.7 % of gross capital formation China 0.6 0.8 1.4 1.4 1.7 2.4 2.8 2.8 2.8 3.3 7.4 14.7 15.1 12.5 12.4 12.9 12.3 10.4 9.9 10.1

721

India 0.2 0.2 0.2 0.0 0.0 0.2 0.2 0.4 0.1 0.4 0.2 0.1 0.5 1.0 1.3 2.3 2.8 3.8 2.8 2.0 2.1 3.2

Note: Indias FDI inows were not adjusted for equality capital and reinvestment earning. Source: World Development Indicators 2003.

What explains the differences? This paper was devoted to explore such question in both qualitative and quantitative ways. In Section 2, several possible explanations were proposed and studied. Using FDI data reported by OECD countries, rather the host countries, in Section 3 random-effect modes were used to estimate separately the determinants of FDI in China and India, and the Oaxaca-Blinder decomposition technique was then applied to quantify the differences that can be contributed by these countryspecic factors. Section 4 concludes.

2. Determinants of difference between China and India in FDI performance A monograph written at the Rajiv Gandhi Institute for Contemporary Studies by John Eliot thus argued that while China indeed was ahead of India in actual FDI, the margin was not nearly as large as was generally assumed (The Financial Express, 2002). In 1994 for instance, while ofcial estimates indicated that Chinas lead over India was 35:1, a more realistic picture was 14:1. More recently, Guy Pfeffermann, Chief Economist of the International Finance Corporation, has lent added credence to this skepticism by arguing that Chinas FDI was actually half of the reported level of $40 billion, while Indias may be

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as much as $8 billion rather than $23 billion. Accordingly, as a share of their respective economies, FDI levels are roughly on par in both the countries. Why is this so? In the following, several possible explanations were proposed: (1) (2) (3) (4) comparability of statistics in FDI; difference in basic economic determinants; difference in development strategy and policies; and difference in overseas network.

2.1. Comparability of statistics in FDI 2.1.1. Difference in the denition of FDI The IMF denition of FDI includes as many as 12 different elements, namely: equity capital, reinvested earnings of foreign companies, inter-company debt transactions, short-term and long-term loans, nancial leasing, trade credits, grants, bonds, non-cash acquisition of equity, investment made by foreign venture capital investors, earnings data of indirectly held FDI enterprises and control premium, non-competition fee, and so on. However, with the singular exception of equity capital reported on the basis of issue/ transfer of equity/preference shares to foreign direct investors, Indias current denition of FDI does not include any of the other above elements. China instead includes all these in its denition of FDI. UNCTAD statistics show that in 20002001, foreign afliates reinvested earnings accounted for one third of all Chinas FDI inows (UNCTAD, 2003). China also classies imported equipment as FDI while India captures these as imports in the trade data. A high-level committee of the Reserve Bank of India (RBI) and the Department of Industrial Policy and Promotion (DIPP) has recommended collection of data in accordance with the international denition of FDI recommended by the International Monetary Fund (IMF). In its preliminary report, The Finance Ministry revised the denition of FDI by incorporating 14 items like equity capital, reinvested earnings and other capitals, to align it with best international practices so that the inows become comparable with other nations. Under the previous denition, the FDI inow was at $2.57 billion US dollars in 2002 2003 scal year compared to $3.91 billion in 20012002 and $2.34 billion in 20002001. Under the revised norms, these gures are boosted to be $4.66 billion in 200203, $6.13 billion in 20012002 and $4.03 billion in 20002001. However, these gures are still about one tenth of those reported by China. 2.1.2. Round-tripping 2.1.2.1. Round-tripping in China. It has been widely acknowledged that Chinas FDI inows are somewhat inated. Reported ows are thought to be overestimated due to overvaluation of capital equipment contributed to joint ventures by foreign investors (the value of which is translated into equity investment and recorded as FDI) and because of roundtripping through Hong Kong, in part to benet from preferential tax treatment accorded to foreigners. Round tripping can take many forms such as under-invoicing exports, over-

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Fig. 1. Round-tripping of capital ows: China and Hong Kong (China), 19861999. Source: World Bank staff estimates.

invoicing imports, and overseas afliates of Chinese companies borrowing funds or raising capital in the stock market and reinvesting them in China. Evidence that round-tripping takes place may be found in the errors and omissions of the balance of payments, whose movements was highly correlated with those of FDI inows (Fig. 1). Other evidence may be found in Chinas FDI outows, especially to Hong Kong, which rose sharply in 1992 at the same time that Hong Kong capital inows to China increased. Hong Kongs share (not dollar amount) of Chinas FDI inows has been declining since 1992. The decline continued after 1997 when Hong Kong was handed over to China. Meanwhile, inows from overseas tax havens such as the British Virgin Islands, Bermuda and Cayman Islands have been on the rise and make up for Hong Kongs declining (Table 3). A rational explanation is that after the hand-over, some investors were concerned enough to abandon Hong Kong for these overseas tax havens. From 1998 to 2002, FDI from the British Virgin Islands accounted for 9% of Chinas inows, but a whopping 177% of its own outows, reecting the size of tax haven routing. In 2003, it was reported that Hong Kong, the Virgin Islands, Samoan and Cayman Islands ranked 1st, 2nd, 8th and 9th in
Table 3 Chinas FDI by source (percent) Source countries/regions Hong Kong, China Virgin Islands, UK United States Singapore Japan Taiwan, China Korea, Democratic Peoples Republic Germany Netherlands France Others Source: Global Development Finance 2002. 1996 50 0 8 0 9 8 0 0 0 1 24 1998 42 9 9 8 8 7 4 2 2 2 7 1999 40 7 10 7 7 6 3 3 1 2 14 2000 38 9 11 5 7 6 4 3 2 2 13

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Chinas 10 largest sources of FDI inows, totaling US$ 25.3 billion or 47% of the aggregate, adding further evidence of round tripping. The estimated magnitude of round-tripping, however, varied signicantly. The World Bank estimated round-trip FDI to be around 25% of total FDI inow in 1992 (World Bank, 1996). Huang (2003) found similar rates. Sicular (1998) estimated it to be higher at 37%. Naughton (1996) estimated that between 1980 and 1992, only 15% of FDI in Shanghai from Hong Kong was round-tripping. Tseng and Zebregs (2002) estimated the rate in 1996 to be only 7%. The most recent estimate is from the World Bank (UNCTAD, 2003). They estimated about 2030% of FDI in China was due to round-tripping, based primarily on Chinas capital ight as reected by the errors and omissions item of the Balance of Payments account. However, according to Xiao (2003), the author of the World Bank report were not quite clear about this complicated issue and did not do thorough rst hand research on this topic. In April 1996, China eliminated exemptions from the value added tax (VAT) and from customs duties on imported capital equipment for foreign funded rms, thus enhancing its national-treatment policy stance towards FDI. With recent improvements in Chinese FDI statistical methodologies and reforms of FDI tax preferences, the magnitude of this problem should be reduced. It has to be note that even after adjusting for round-tripping, China is still far ahead of India in FDI (Table 4). In 2003, Chinas FDI was 39.6 billion if 25% of the total FDI was round-tripping; this was still nearly ten times of that in India, with the latter gure already being adjusted. 2.1.2.2. Round-tripping in India. In terms of shares, FDI from Mauritius into India is like FDI from Hong Kong into China. Mauritius has been the dominant source of FDI inows into India since 1995. In 20012002, FDI from Mauritius alone constitute 60% of the total FDI in India (Table 5). Most investments into India through Mauritius are affected through Mauritius Offshore companies (MOCs) which are special purpose vehicles best suited to foreign investors who wish to utilize Mauritius as an investment platform beneting from its network of double Taxation Treaties. Despite the huge share of FDI from Mauritius, in India, corporate tax rates are the same for all companies. Reserve Bank of India was reported to have found that the percentage of round tripping in India as a part of the total FDI is almost insignicant, maybe as low as 23% (REDIFF.com, 2003).
Table 4 Comparison of FDI in China and India with adjustment (Amt: US$ billion) Fiscal year reported FDI In India Before adjustment 2.34 3.91 2.47 After adjustment 4.66 6.13 4.03 Year reported FDI in China Original 40.71 46.88 52.74 If 10% round-tripping 36.64 42.19 47.47 If 25% round-tripping 30.53 35.16 39.56

20002001 20012002 20022003

2000 2001 2002

Source: Data on FDI in India are from Reserve Bank of India. Indias scal year starts from March. Data on FDI in China are from the Ministry of Commerce of PR China.

W. Wei / Journal of Asian Economics 16 (2005) 719736 Table 5 Source-country composition of FDI in India (20012002 scal year) Country Germany Italy Japan Mauritius Netherlands South Korea US Other Total Source: Reserve Bank of India. $ US Million 74 28 143 1863 68 3 364 445 2988

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Percent 2.5 0.9 4.8 62.3 2.3 0.1 12.2 14.9 100

2.2. Basic economic determinants On the basic economic determinants of inward FDI, China does better than India (Table 6).  Chinas total and per capita GDP are higher, making it more attractive for marketseeking FDI.  Its higher literacy and education rates suggest that its labor is more skilled, making it more attractive to efciency-seeking investors.  China also has large natural resource endowments. In addition, Chinas physical infrastructure is more competitive, particularly in the coastal areas. But, India may have an advantage in technical manpower, particularly in information technology.  China has a gigantic domestic market with a system of mass production. This reduces the cost of production considerably. That is why, China is the rst choice of multinationals for setting up a wholly export-oriented unit. India too offers an equally attractive environment. There is no dearth of technically qualied manpower available cheaper than in the West. But India has yet to evolve a system of bulk production at the scale prevalent in China. In a recent working paper by Liu, Liu, and Wei (2002), it was found that international trade, FDI and its interaction with labor quality improvement play a signicant role in improving efciency of an economy. Specically, they found India performed better than China in raising productivity until the mid-1990s. However, China has experienced a higher degree of openness and therefore a faster rate of catching-up with the worlds best practice. This, in turn, further makes China more attractive to foreign investors. 2.3. Development strategies and policies China also does better in attracting FDI because of its FDI attitudes, policies and procedures.

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Table 6 Basic economic indicators: China vs. India Economic indicators 1980 China GDP per capita (1995 constant US$) % of GDP Export of goods and services % of Manufactured exports with high-technology Import of goods and services Current balance Value added as % of GDP Agriculture Industry Services, etc. Selected economic indicator Lending interest rate Phone subscribers (per 1000 people) Adult illiteracy rate % Internet users of total population a Selected industrial output Crude steel (million metric tons)b Electricity (billion kwh) 166.7 7.6 n.a. 7.9 2.8 30.1 48.5 21.4 5.0 n.a. 32.9 n.a. n.a. 300.6 India 228.3 6.3 n.a. 9.5 2.0 38.9 24.5 36.6 16.5 n.a. 59.0 n.a. n.a. 119.3 2002 China 941.9 26.9 23.3 25.4 2.0 14.8 51.2 34.0 5.3 247.7 13.6 6.0 181.6 410.7 India 494.0 15.2 4.8 16.1 1.2 22.9 26.0 51.2 11.9 43.8 41.2 1.5 28.8 183.4

Source: World Development Indicators 2003. a Source: Internet World Stats at http://www.internetworldstats.com/stats3.htm, last accessed date: 10th May, 2004. b Source: International Iron and Steel Institutions, World Steel in Figs. 2003 edition, at http://www.worldsteel.org/media/wsif/wsif2003.pdf, last accessed date: 10th May, 2004.

 China has more business-oriented and more FDI-friendly policies than India. Chinas FDI procedures are easier, and decisions can be taken rapidly. The World Bank Group carried out a survey of a sample of rms in China and India (UNCTAD, 2002, 2003) and found that, on average, it teaks 10 permits compared to 6 in China, and 90 days in India relative to 30 days in China, to start up a new business. It also reported that it took 43 clearance at the central government level and 57 at the state level when it came to a foreign-invested power plant.  China has more exible labor laws, a better labor climate and better entry and exit procedures for business (CUTS, 2003). A recent business environment survey indicated that China is more attractive than India in the macroeconomic environment, market opportunities and policy towards FDI. India scored better on the political environment, taxes and nancing (EIU, 2003). A condence tracking survey in 2002 indicated that China was the top FDI destination, displacing the United States for the rst time in the investment plans of the TNCs surveyed; India came 15th (A.T. Kearney, 2002). A Federation of Indian Chambers of Commerce and Industry (FICCI) survey suggests that China has a better FDI policy framework, market growth, consumer purchasing power, rate of return, labor laws and tax regime than India (FICCI, 2003). Development strategies and policies. The different FDI performance of the two

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countries is also related to the timing, progress and content of FDI liberalization in the two countries and the development strategies pursued by them.  China opened its doors to FDI in 1979 and has been progressively liberalizing its investment regime. India allowed FDI long before that but did not take comprehensive steps towards liberalization until 1991 (Nagaraj, 2003).  The two countries focused on different types of FDI and pursued different strategies for industrial development. India long followed an import-substitution policy and relied on domestic resource mobilization and domestic rms (Bhalla, 2002; Sarma, 2002), encouraging FDI only in higher-technology activities. Despite the progressive liberalization, imposition of joint venture requirements and restrictions on FDI in certain sectors, China has, since its opening, favored FDI, especially export-oriented FDI, rather than domestic rms (IMF, 2002). Some researches and surveys, however, found India actually had not performed worse, if not better, than China. A World Business Environment Survey (WBES) was made in 19992000 in 80 countries plus one territory covering 10,000 rms in manufacturing, services, agriculture, construction, which are mostly small but also medium and large (World Bank, 2000). This survey showed that China is better than India although neither climate is anything to write home about (Table 7) An Economic Freedom Index Survey held in 2003 (The Heritage Foundation, 2003) found that China scores better than India only in macro management and low taxes. But India scores better than China in degree of government intervention, treatment of foreign investment and respect for property rights (Table 8). 2.4. Overseas networks It is also argued that China is a large recipient of FDI mostly because of the investments from her non-resident Chinese (NRC), chiey from that resident in East Asian countries
Table 7 World Business Environment Survey 2000 India Taxes and regulations Financing Infrastructure Policy instability Ination Exchange rate Street crime Organized crime Anti-competitive policies Corruption Overall 2.28 2.55 2.77 2.84 2.87 2.48 1.99 1.9 2.8 2.49 China 2.08 3.35 1.96 2.27 2.28 1.79 1.8 1.72 2.17 2.03 2.15

Source: The World Bank, 2002. (URL: http://www.marubeni.co.jp/research/index/0212/index.html) last accessed date: 10th May, 2004. Note: The lower the score the better.

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Table 8 World economy freedom index 2003 India Trade policy Government intervention Foreign investment Wages and prices Regulation Fiscal burden Monetary policy Banking and nance Property rights Black market Overall 5 3 3 3 4 4 2 4 3 4 3.5 China 5 4 4 3 4 3 1 4 4 3.5 3.55

Source: The Heritage Foundation, November 2003. Note: The lower the score the better.

including Hong Kong. Gao (2003) found a signicant positive role in inward FDI of ethnic Chinese networks proxied by the population share of ethnic Chinese in the investing country. In fact, because of their cultural afnity with those in the Mainland China, the NRC may be better placed to take advantage of the location advantages the Mainland offers. And a substantial proportion of investments from Hong Kong may originate from western countries and routed through Hong Kong, a leading nancial centre in the region. There is also the suggestion that non-resident Indian (NRI), which is sizeable, have mostly preferred to invest in bank deposits in their country as residence as opposed to FDI and hence the low levels of FDI in India. The differing composition of the non-resident Chinese and non-resident Indians, in fact, provides one reason for the differences in the volume of FDI the two countries have attracted. Although there are no precise data on the size and composition of the NRC and NRI, available evidence suggests that whilst non-resident Indians are located mostly in the US, the UK and other western countries, Chinese non-residents are mostly located in East Asia. The Indian non-residents, especially sin the US, mostly belong to the professions including education, health services and science and engineering oriented professions. The Chinese non-residents are however business oriented. The opening up of China to trade and investment appears to have provided the Chinese non-residents the opportunity to extend and or shift their business interests to the mother country to take advantage of relatively low cost labor and land. The Indian non-residents with their lack of business interests have for long opted for the portfolio variety of investments principally bank deposits. In contrast Chinas exports largely consist of labor-intensive exports, around 5060% of total exports, mostly though not wholly on account of Chinese non-residents investments. It is also shown that what little NRI investments India has attracted are export oriented, mostly labor-intensive exports such as garments. The inescapable conclusion must be that Indian non-residents are vastly different in their background and orientation and perhaps in size from the Chinese non-residents. This is one of the reasons for the relatively low volumes of FDI from NRIs in India.

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3. Econometric analysis of difference in FDI between China And India In the section above, two types of differences causing the gap of FDI inow between China and India were identied: (1) fake differences resulting from difference in statistical methods in FDI, namely, inclusion criteria and round-tripping; (2) real differences resulting from difference in basic economic determinants and government policies. Therefore, to get a clear picture of the gap, we need to address both issues. In this section, based on FDI data reported by host OECD countries, which has a unied denition, I rst used random effect models to estimate the determinants of FDI in China and India separately, and then used an econometric decomposition method to quantify the contribution of each factor to the gap. 3.1. Method 3.1.1. Determinants of inward FDI in China and India Based on the existing literature on determinants of inward FDI in developing countries (De Mello, 1997; Froot & Stein, 1991; Grosse & Trevino, 1996; Moore, 1993; Ramcharran, 1999), the following economic relationship is proposed: FDIit f RGDP ; REX ; RIM ; RW ; RER ; RBC ; it it it it it it RCR ; TCD ; GEOD ; TREATY it it it it (1) where RFDI: the annual real inward FDI; RGDP: the ratio of real home country GDP to real host countrys GDP; REX: real host countrys exports to the home country; RIM: real host countrys imports from the home country; RWAGE: the ratio of home countrys real wage to host countrys real wage; RER: the ratio of home countrys currency/US$ real exchange rate to the host countrys currency /US$ real exchange rate; RBC: the ratio of the home countrys real lending interest rates to host countrys real lending interest rates; RCR: the ratio of country risk ratings for the home country to that for the host country; TCD: Cultural difference between the host country and the home country; GEOD: geographic distance between the host country and the home country; TREATY: annually signed bilateral investment treaties by the host country. where + and denote the direction of the expected effect of the factors on FDI from the home country in the host county. The model is of the form: RFDIit CAi RGDPb1 REXb2 RIMb3 RWAGEb4 RERb5 it it it it it RBCb6 RCRb7 TCDb8 GEODb9 DTTb10 BITb11 et it it it it it it The log-linear form of the above equation is: ln RFDIit b1 ln RGDPit b2 ln REXit b3 ln RIMit b4 ln RWAGEit b5 ln RERit b6 ln RBCit b7 ln RCRit b8 ln TCDi b9 ln GEOi b10 ln DTTt b11 ln BITt mit i 1; 2; N; t 1; 2; T (3) (2)

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where i and t denote country/region and time respectively, N is the total number of countries/regions in the sample, T is the overall time period and mit represents the error term and will be discussed in detail. All of the independent variables are measured simultaneously with FDI because the impact of these factors is expected to occur either simultaneously with FDI (e.g., cultural and geographic distance) or with a lag of a few months or longer (e.g., exchange rates, bilateral trade). Thus all factors could be seen as (weakly) exogenous, allowing standard panel estimation to be applied. There are several advantages of adopting a log-linear form. First, in the case of FDI in China, there are extreme values arising from surges of inows in some years and from certain OECD countries. The use of logarithms may counteract this problem statistically. Second, it can transform a likely non-linear relationship between inward FDI in China and the explanatory variables into a linear one. Thirdly, the bs in the log-linear model (3) directly measure FDI elasticities with respect to the explanatory variables. Alternatively, these coefcients may be interpreted as the partial derivatives of the growth rate of FDI with respect to the growth rate of the explanatory variables. Given the panel structure of this study, several are applied to identify the best statistical model. The Lagrange multiplier (LM) test was used to test for the random-effect (RE) model against the pooled OLS model. Choice between FE model and RE model is not easy to make. Hsiao (2003) notes that the xed effects model is normally used to make inferences conditional on the effects that are in the sample while the random effects model is applied to make unconditional or marginal inferences with respect to the population of all effects. Practically, FE approach is also costly in terms of degrees of freedom lost. In studying FDI in China, Liu, Song, Wei, and Romilly (1997) only used RE model because, same as the current study, their model contains two time-invariant variables: total cultural differences (TCD) and geographic distance (GEOD). The application of the FE model will lead to a problem of perfect multicollinearity. However, they provided no statistical test to back up their argument. Dees (1998), on the other hand, adopted FE model without even mentioning its appropriateness. Hausman m-statistic (Hausman, 1978) provides specication test about the appropriateness of the RE model versus FE model and was tested. Autocorrelation was tested by the BaltagiWu locally best invariant (LBI) test (1999). Model tness was measured by Buses R-squared (1973). The above regression was applied to China and India separately. 3.1.2. Oaxaca-blinder decomposition of the gap in inward FDI Some of the differences in FDI inow between China and India can be explained by the differences in the characteristics of both the source country and the home country. I used the Oaxaca-Blinder decomposition approach (Blinder, 1973; Oaxaca, 1973) to examine the contribution of host and home country characteristics to the gap in inward FDI between China and India. As long as the expected mean of the error terms in the regressions are both zero, the total estimated gap in FDI inow between China and India can be represented by: 0 0 ln RFDIChina ln RFDIIndia bChina XChina bIndia XIndia (4)

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where bChina and bIndia represent, respectively the estimated coefcients of the log-linear regression for China and India, and XChina and XIndia represent, respectively the average characteristics of China and India relative to the FDI home countries. The total estimated gap can be further decomposed into the following two components: ln RFDIChina ln RFDIIndia bChina XChina XIndia bChina bIndia 0 XIndia
0

(5)

The rst component is the explained portion of the gap, which is sum of the differences China and India in their observed characteristic weighted by Chinas estimated coefcients. The second component is the unexplained portion of the gap, which is the sum of differences in China and Indias estimated coefcients weighted by Indias endowments. There is an obvious index-number problem here as one can instead evaluate the rst component of (5) by Indias estimated coefcients, and the second component by Chinas endowments. For the current study I examined both alternatives as originally proposed by both Oaxaca (1973) and Blinder (1973) because there is no optimal solution to this problem (Cotton, 1988; Neumark, 1988; Reimers, 1983). The analyses yielded similar results and therefore I only reported the one using womens regression coefcients. I also reported the contribution of each characteristic to the total gap, as a percentage of the total FDI gap. For example, the contribution of FDI differences in the distribution of market size (proxied by relative GDP of home country to that of host country) to the estimated total gap between China and India is calculated as: Market Market Market Market bChina 0 XChina bChina 0 XIndia 100 0 0 bChina XChina bIndia XIndia (6)

which is the estimated FDI into China if its distribution in relative market size had been the same as India, divided by the total gap, represented in percentage points. In Eq. (6), bMarket China is the estimated coefcient of RGDP in the log-linear regression on FDI into China, and Market XChina is the average relative market distribution for China. 3.2. Data Instead of using FDI data reported by China and India authorities, in this analysis I used data on outward FDI to China and India reported by OECD countries, i.e., the home countries. By using this data, two problems can be solved: (1) round-trippingsince the data doesnt include FDI from Hong Kong, Mauritius and other off-shore nancial centers, FDI reported in the data can be safely regarded as real FDI. (2) Statistical compatibilitysince the data were reported by the home country, rather than the host country, the same denition of FDI was used. The source of the data on FDI is from International Direct Investment Statistical Yearbook 2003 (Organization for Economic Co-operation and Development (OECD), 2003). Data sources on other variables are detailed in the appendix. The study period was from 1987 to 2000, and 15 OECD countries were included in the analysis: Austria,

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Belgium-Luxembourg, Denmark, Finland, France, Germany, Italy, Japan, Korea, Netherlands, Spain, Sweden, Switzerland, United Kingdom, and United States. 3.3. Empirical results On average, FDI in China is $324 million US dollars per OECD country per year, which is more than six times of that in India ($57 million US dollars per OECD country per year). 3.3.1. Results for the random-effect modelChina and India The results of the estimation of the random-effect model are reported in Table 9, for China and India, respectively. In the models for both China and India, LM tests and Hausman test statistics (with timeinvariant variables dropping from the model) indicate that the random effect model is appropriate, comparing with the pool OLS model or xed-effect mode. 3.3.1.1. Chinas model. All factors have the expected sigh, but only the effects of relative market size, international trade ties (export and import), and relative real exchange rate are signicant. Contrasting with the ndings in the previous chapter, the effect of relative real wage is not signicant, although still positive. These ndings, all together, suggest that Chinas domestic market, rather than the low labor cost, is the major driving force of attracting FDI from OECD countries. 3.3.1.2. Indias model. All the factors have the expected sigh, except the geographic distance. The effects of relative real GDP, real import, relative real wage, relative country
Table 9 Regression estimates of elasticities for FDI inow from OECD countries Variables Constant Relative real GDP Real export from China Real import to China Relative real wage Relative real borrowing cost Relative real exchange rate Relative country risk Cultural difference Geographic distance Annual # of investment treaties issued Buse R2 BaltigiWu LBI (modied Durbin-Watson) LM test Hausman M statistics for RE effect Note: gures in parenthesis are standard errors. * Stands for signicant effect at 10% level. ** Stands for signicant effect at 5% level. *** Stands for signicant effect at 1%. Host country: China 64.75 (59.23) 2.43*** (0.73) 0.63 (0.41) 0.53* (0.28) 0.84 (1.12) 0.54 (0.37)I 1.21*** (0.50) 0.77 (0.96) 10.76 (12.84) 2.21 (2.94) 0.25 (0.19) 0.46 1.38 11.07*** 5.88 Host country: India 28.27 (113.40) 2.29** (1.13) 0.80 (0.60) 0.79** (0.36) 2.03*** (0.54) 0.24 (0.45) 0.61 (0.46) 1.84*** (0.72) 1.13 (10.78) 1.92 (9.42) 0.24* (0.15) 0.48 1.48 10.98*** 6.93

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risk, and double-tax treaty signed annually are signicant. These ndings suggest that, unlike China, India attracted FDI from OECD countries by both its domestic market and its cheap labor cost. Investors from OECD countries were sensitive to the relative nancial risk when making investment decisions in India. Also the government policies favoring FDI adopted after the 1991 reform seem to be working well. 3.3.2. Oaxaca econometric decomposition of difference in FDI from OECD countries between China and India Table 10 reports the econometric decomposition of the gap in FDI inow from OECD countries between China and India. Weighting by Chinas coefcients, the model predicted that 50% of the difference would be eliminated if India had identical observable characteristics as China. Larger domestic market, stronger international trade ties helps China increasing its lead in attracting FDI from OECD countries, while lower labor cost, constantly depreciating exchange rate, and improved country stability helps India in catching up with China in attracting FDI from OECD counties. For example, Chinas potentially huge domestic market helps China wide the gap by almost 80%, while Indias cheaper labor cost helps decreasing the gap by 50%. Closer geographic distance and similar cultural background helps India in decreasing the gap, however, by 18% and 8%,
Table 10 Econometric decomposition of difference between China and India in OECD-country FDI inows Mean of Chinas ln $ Real FDI Mean of Indias ln $ Real FDI Difference Predicted FDI inow and decomposition of FDI difference Assumed characteristics 1 2 3 4 5 6 China India China India Predicted gap (12) Gap due to difference in characteristics (32) Assume coefcients China India India China Predicted mean of ln$ real FDI 4.049 2.384 3.220 7.239 1.665 0.836 % of gap explained * 79.7 59.3 60.6 50.1 6.0 48.3 27.0 18.2 7.6 7.9 50.2 4.4524969 2.9415502 1.5109467

Gender difference due to Relative real GDP Real export from host country Real import to host country Relative real wage Relative real borrowing cost Relative real exchange rate Relative country risk Cultural difference Geographic distance Annually signed investment treaties Total

Note: The symbol asterisk (*) denotes results from decomposition based on Chinas estimated coefcients.

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respectively. China seemed perform better in terms of its government policy towards FDI, in the sense that the higher number of annual double-tax treaty issued by China helps it to increase the gap by 8%.

4. Conclusions Many scholars believed that the huge difference between China and Indias FDI has been quite over-estimated. However, no study so far has explored the source of the difference and provides convincing quantitative proof. This study aims to ll in such a gap by using FDI panel data reported by home countries, rather than host countries, to explore the difference. Random-effect models was used to estimate the determinants of FDI inows in China and India and then an econometric decomposition method was used to quantify the contribution of these country-specic characteristics in explaining the gap. The analyses in the current study suggest that: Chinas potentially huge domestic market is the major determinant of its inward FDI from OECD countries, while for India, both domestic market and cheap labor cost are important determinants of its inward FDI from OECD countries. Comparing to India, Chinas better performance in attracting FDI from OECD countries was mainly due to its larger domestic market and higher international trade ties with OECD countries. India, on the other hand, had advantage in its cheaper labor cost, lower country risk, geographic closeness to OECD countries, and cultural similarity. These advantages helped India decrease the gap in FDI. The results here need to be interpreted with caution because FDI from OECD countries were not the major portion of their inward FDI in either China or India. Also some small OECD countries who reported FDI in only China, or India were excluded from the analysis, although the bias introduced may not be signicant.

Appendix A. Data sources (1) RGDP: The relative real GDP, dened as the ratio of home countrys real GDP to that of China. GDP is in 1995 constant US million $ and are from World Development Indicators 2003; (2) REX and RIM: Host countrys real export to home countries and import from home countries, derived from nominal export/import deated by Chinas GDP deator (1995 = 100). Trade data are from UNs Comtrade database. (3) RW: Relative Real Wage, dened as the ratio of home countrys monthly nominal wage deated by consumer price index (CPI 1995 = 100) to that of the host country. Data are from International Labor Organization (ILO)International Labor Statistical Yearbook. Ideally, wages should be adjusted for labor productivity to yield unit labor costs. However, distortions in the value of output (during the time period in question) due to price controls and other government interventions in the market render productivity measures problematic. Using such measures would likely create additional noise in the wage variable (data which is already subject to the usual

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(4)

(5)

(6)

(7)

(8)

(9)

imperfections in China and India s statistics). The wage variable represents explicit payments to workers. RER: Relative real exchange rate, derived from the ratio of the real home country currency/US$ exchange rate to that of the host country. The real exchange rate is derived from the ofcial exchange rate deated by the CPI deator (1995 = 100). Sources: International Financial Statistical Yearbook and World Development Indicators 2003. RBC: Relative real borrowing cost, derived from the ratio of home countrys nominal lending interest rates adjusted by consumer price index (CPI 1995 = 100) to that of the host country. Source: International Financial Statistics Yearbook. RCR: Relative country risk, dened as the ratio of home countrys annual country risk ratings to that of the host country. The higher the ratio, the riskier of the host country relative to the home country. Source: Institutional Investors, various issues. The country risk ratings are based on information provided by leading international banks, money management rms and economists. They were asked to grade each of the countries on a scale of zero to 100, with zero representing the least-creditworthy countries and 100 representing those with the least chance of bank default. TCD: Total cultural difference. In Hofstedes book (2001), he dened culture to be the shaping of the mind that distinguishes the members of one group or category of people from those of another. It is expressed as the collective values, norms, traditions, myths and institutions that are characteristic among members of a group. He developed indices to measure four dimensions of cultural difference related to management. These include power distance, uncertainty avoidance, individuality and masculinity/femininity. As constructed by Grosse and Goldberg (1991), the total cultural difference is the sum of the absolute values of the four-dimension differences. GEOD: The geographic distance between home country and the capital of the host country: Beijing. Source: Centre dEtudes Prospectives et dInformations Internationales (CEPII) TREATY: Annually assigned bilateral investment treaties by the host countrys government. Source: World Investment Directory 2003.

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