Do Domestic Firms Become Cleaner in the Presence of FDI? Testing FDI Spillover Effects on Firm Air Pollution in China

This paper investigates the effect of foreign direct investment (FDI) on domestic firms’ air pollution emissions in a developing country context. We provide quasi-natural experiment evidence from China, using a plausibly exogeneous relaxation of FDI regulations upon China’s WTO accession in 2001. Based on a panel of domestic major polluting firms of 1998-2007, we compare firm emissions in FDI-encouraged industries with firm emissions in unchanged industries before and after the WTO accession, using a difference-in-differences (DID) estimation. We find that FDI deregulation increases domestic firms’ air pollution emissions. Causal mechanisms show evidence for both agglomeration and competition effects; yet the competition effect dominates the agglomeration effect, resulting in an overall increase in firm emissions. Further, the competition effect mostly affects firm emissions through the production process rather than during the end-of-pipeline abatement stage. Finally, our main results do not change after we rule out potential reallocation and selection effects