Why is U.S. direct investment in China so small

KEVIN HONGLIN ZHANG [*] While the United States is the largest source of foreign direct investment (EDI) in the world, and China is the largest FDI recipient among developing countries, U.S. direct investment (USDI) in China has been surprisingly small. This article investigates the determinants of USDI through a relative-demand model with time-series data. Evidence presented in this article indicates that the small USDI cannot be fully appreciated without understanding differences between USDI and Hong Kong direct investment (HKDI), the latter being the dominant source of FDI in China. Empirical results suggest that the USDI in China was primarily motivated by market access and that the HKDI was export oriented. The small USDI thus is a result of U.S. investors' preference for market access and China's export-promotion FDI regime, along with the troubled Sino-US. relations and political instabilities in China. (JEL F21, F23, O53) I. INTRODUCTION The United States for a long time has been the dominant source of foreign direct investment (FDI) for developing countries as well as developed countries. China has become the largest recipient of FDI among developing countries and the second only to the United States in the world since 1993 (IMF, 1997). However, most FDI received in China came not from the United States but from Asian developing economies, particularly Hong Kong. As shown in Table 1, while China hosted 32% of FDI in all developing countries during its FDI-boom period of 1992-96, U.S. direct investment (USDI) constituted less than 8% of total FDI in China, contrasting to 41% of USDI in other developing countries in that period. [1] In fact, the USDI flows per capita have been much lower in China than in many other developing countries that do not have location advantages over China in market size, labor costs, and income growth (BEA, September 1997). The relatively small USDI in China raises a question of how well the theories of FDI explain the interaction of U.S. investors and China's location characteristics. While there is considerable literature on both the USDI in developing countries (e.g., Kravis and Lipsey, 1982; Wheeler and Mody, 1992) and inward FDI in China (e.g., Kamath, 1990; Casson and Zheng, 1991; Wang and Swain, 1995), the puzzle of the small USDI in China has not been addressed. This article thus investigates the issue by assessing China's location advantages and disadvantages in attracting USDI relative to other developing countries. Shedding light on the issue should be of importance in policy implications. For China, to keep large FDI flows including USDI shall not only enhance its economic growth, but also be necessary to upgrade its industrial structure through absorbing advanced technology embodied in USDI. For the United States, dealing with China is inevitable, as it is an emerging market and power. The USDI might become a policy tool for the United States, no matter whether the objective is to contain, or have an engagement with China. This article tests for determinants on USDI through a relative demand model with time-series data. Especially, the behavior of U.S. investors is analyzed in comparison with that of investors from Hong Kong, the dominant FDI source in China. Hong Kong direct investment (HKDI) has constituted over one half of China's inward FDI in almost every single year since 1977. [2] The evidence presented in this article suggests that China's location advantages and disadvantages have received different responses from U.S. and Hong Kong investors. The USDI has been induced essentially by China's potentially huge market and trade barriers, but the amount of USDI flows has been limited largely due to China's restrictive policy toward the market-oriented FDI and troubled Sino-U.S. relations. The HKDI primarily is export oriented, which has been encouraged by China's cheap labor and incentive policies toward this type of FDI. …