Targeted Liberalization: China's foreign investment regulation reform and its post‐WTO‐accession export surge

Abstract

To gain membership in the World Trade Organization (WTO) in 2001, China substantially modified its regulation of foreign direct investment. These reforms coincided with rapid changes in the composition of capital inflows, as the dominant entry mode shifted from joint venture to wholly foreign owned affiliate. Foreign‐invested enterprises contributed a rising share of China's rapidly growing exports. We investigate how much China's foreign ownership liberalization contributed to these observed trends in foreign investment flows and Chinese exports. Accounting for both the set of activities from which it removed foreign equity caps and those into which it newly encouraged investment, we estimate the impact of China's reforms on firm entry and exports using a difference‐in‐differences estimator. To eliminate bias resulting from heterogeneous and dynamic treatment effects, we also apply novel dynamic difference‐in‐differences estimators. We find that removal of foreign equity caps induced entry of wholly foreign owned firms, while having no significant effect on entry of new joint ventures. Concurrently, the designation of new activities for investment incentives induced foreign entry, particularly in the form of joint ventures. Reduced‐form calculations imply that FDI policy changes explain almost 9% of the increase in exports from foreign‐invested firms over the decade studied. The effect was larger in sectors identified as “high‐tech industries” by the Chinese government, as they contribute most of the estimated policy‐driven export growth from foreign‐invested firms. Thus, China's FDI regulation reform following WTO entry was targeted liberalization: elimination of equity share limits induced new foreign entry, while investment incentives encouraged formation of joint ventures.