Modes of foreign direct investment and patterns of trade: Why do multinational enterprises come To China?

This paper investigates the link between patterns of trade and modes of foreign direct investment (FDI) by utilizing exports, imports, and inward FDI data for China over the period 1998 to 2007. We construct a modified gravity equation to find the main modes of inward FDI into China with considering spatially interdependent third country effect. The problem of endogeneity is controlled by applying the system generalized method of moments (GMM) estimation technique. We find that there is no evidence of statistically significant substitutability and complementarity between bilateral trade and FDI in the aggregate data. On the contrary, the trade-diverting third country effect of inward FDI is proven to be strong. As we decompose the aggregate trade goods into final and intermediate goods, we find that there is strong evidence of vertical FDI for importing intermediate goods from the home country and exporting final goods back to the home country. However, the motivation of vertical FDI has been diminishing and the modes of export-platform and complex vertical FDI have begun to emerge. This implies that China has imported intermediate inputs from the home country of FDI, produced final goods or parts and components, and exported them back to the home country. Recently, however, we have noticed that there has been a diversion trend of the vertical linkage from home country to third countries. This indicates that the main mode of inward FDI into China has been shifting from “home export base” to “third country export base”.