A Tale of Two Provinces:The Institutional Environment and Foreign Ownership in China Huang Yasheng and Di Wenhuab MIT Sloan School of Management School of Economic,Political and Policy Sciences,University of Texas at Dallas ABSTRACT In this paper,we use a unique dataset covering the joint ventures in Jiangsu and Zhejiang,two provinces of China,to test the effect of the institutional environment for domestic private firms on the ownership structures of FDI projects.Applying the prevailing bargaining framework in studying the ownership structures of FDI projects from the perspective of local firms seeking FDI,we find that the legal and financial constraints imposed on the more efficient domestic firms (i.e.private firms)to benefit the less efficient ones(i.e.TVEs)may have forced private firms to seek legal protection and financial resources in some ways-including forming alliances with foreign firms.Strong FDI preferences and/or weak capabilities may cause the private entreprises to make more equity concessions to foreign firms with whom they are to establish joint ventures.The more liberal the institutional environment for domestic private firms,the smaller the share of foreign investment in the joint ventures. 1 We thank the anonymous reviewer from China Finance Review for comments on an earlier version of this paper. Yasheng Huang 50 Memorial Drive,E52-562,Cambridge,MA,02142.Tel:+1 617253 9768;fax:+1617253 2660.Email addresses:yshuang @mit edu:wenhua.di@utdallas.edu 1
1 A Tale of Two Provinces: The Institutional Environment and Foreign Ownership in China1 Huang Yashenga* and Di Wenhua b a MIT Sloan School of Management b School of Economic, Political and Policy Sciences, University of Texas at Dallas ABSTRACT In this paper, we use a unique dataset covering the joint ventures in Jiangsu and Zhejiang, two provinces of China, to test the effect of the institutional environment for domestic private firms on the ownership structures of FDI projects. Applying the prevailing bargaining framework in studying the ownership structures of FDI projects from the perspective of local firms seeking FDI, we find that the legal and financial constraints imposed on the more efficient domestic firms (i.e. private firms) to benefit the less efficient ones (i.e. TVEs) may have forced private firms to seek legal protection and financial resources in some ways—including forming alliances with foreign firms. Strong FDI preferences and/or weak capabilities may cause the private entreprises to make more equity concessions to foreign firms with whom they are to establish joint ventures. The more liberal the institutional environment for domestic private firms, the smaller the share of foreign investment in the joint ventures. 1 We thank the anonymous reviewer from China Finance Review for comments on an earlier version of this paper. * Yasheng Huang: 50 Memorial Drive, E52-562, Cambridge, MA, 02142. Tel: +1 617 253 9768; fax: +1617 253 2660. Email addresses: yshuang@mit.edu; wenhua.di@utdallas.edu
A Tale of Two Provinces:The Institutional Environment and Foreign Ownership in China ABSTRACT In this paper,we use a unique dataset covering the joint ventures in Jiangsu and Zhejiang,two provinces of China,to test the effect of the institutional environment for domestic private firms on the ownership structures of FDI projects.Applying the prevailing bargaining framework in studying the ownership structures of FDI projects from the perspective of local firms seeking FDI,we find that the legal and financial constraints imposed on the more efficient domestic firms(i.e.private firms)to benefit the less efficient ones(i.e.TVEs)may have forced private firms to seek legal protection and financial resources in some ways-including forming alliances with foreign firms.Strong FDI preferences and/or weak capabilities may cause the private entreprises to make more equity concessions to foreign firms with whom they are to establish joint ventures.The more liberal the institutional environment for domestic private firms,the smaller the share of foreign investment in the joint ventures. JEL classification:F21;F23;C21;O53 Key words:China,FDI,private sector,institutional environment,joint venture 2
2 A Tale of Two Provinces: The Institutional Environment and Foreign Ownership in China ABSTRACT In this paper, we use a unique dataset covering the joint ventures in Jiangsu and Zhejiang, two provinces of China, to test the effect of the institutional environment for domestic private firms on the ownership structures of FDI projects. Applying the prevailing bargaining framework in studying the ownership structures of FDI projects from the perspective of local firms seeking FDI, we find that the legal and financial constraints imposed on the more efficient domestic firms (i.e. private firms) to benefit the less efficient ones (i.e. TVEs) may have forced private firms to seek legal protection and financial resources in some ways—including forming alliances with foreign firms. Strong FDI preferences and/or weak capabilities may cause the private entreprises to make more equity concessions to foreign firms with whom they are to establish joint ventures. The more liberal the institutional environment for domestic private firms, the smaller the share of foreign investment in the joint ventures. JEL classification: F21; F23; C21; O53 Key words: China, FDI, private sector, institutional environment, joint venture
1.Introduction Since 1979,foreign-invested enterprises(FIEs)-firms funded by FDI-have become a sizable player in Chinese economy.FIEs are making China a manufacturing base in Asia.They can be found in virtually every part of China and in every economic sector.FIEs have established dominant positions in a number of Chinese industries.The foreign trade activities of FIEs account for a significant share of China's overall trade.By 2002,they have accounted for over 50 percent of China's exports. A number of studies analyzing the determinants of the ownership structures of FIEs in China have been done by Pan(1996),Pan and Tse(1006),Pan et al.(1999)and others.Most of these studies approach the question from the perspective of the foreign-invested firms.They emphasize those variables in the regression specifications that are prominently featured in the theoretical and empirical studies of multinational corporations(MNCs),such as industrial characteristics,firm-specific assets,and technologies.The basic building block in on the studies of the determinants of equity structures of FDI firms is the industrial organization(IO) conceptualization.The starting point is that foreign firms will incur additional costs while domestic firms will not.The costs include the intrinsic difficulties of managing cross-border operations,and those of gathering information and developing expertise in relation to foreign markets and the political,social,and legal environments.To offset these extra costs,a foreign firm must have internal and ownership-specific advantages-such as R&D capabilities-over its domestic rivals.2 2 The pioneering work in this field of study is Hymer(1976).For a good summary of this large body of literature, see Caves(1996) 3
3 1. Introduction Since 1979, foreign-invested enterprises (FIEs)—firms funded by FDI—have become a sizable player in Chinese economy. FIEs are making China a manufacturing base in Asia. They can be found in virtually every part of China and in every economic sector. FIEs have established dominant positions in a number of Chinese industries. The foreign trade activities of FIEs account for a significant share of China's overall trade. By 2002, they have accounted for over 50 percent of China’s exports. A number of studies analyzing the determinants of the ownership structures of FIEs in China have been done by Pan (1996), Pan and Tse (1006), Pan et al. (1999) and others. Most of these studies approach the question from the perspective of the foreign-invested firms. They emphasize those variables in the regression specifications that are prominently featured in the theoretical and empirical studies of multinational corporations (MNCs), such as industrial characteristics, firm-specific assets, and technologies. The basic building block in on the studies of the determinants of equity structures of FDI firms is the industrial organization (IO) conceptualization. The starting point is that foreign firms will incur additional costs while domestic firms will not. The costs include the intrinsic difficulties of managing cross-border operations, and those of gathering information and developing expertise in relation to foreign markets and the political, social, and legal environments. To offset these extra costs, a foreign firm must have internal and ownership-specific advantages—such as R&D capabilities—over its domestic rivals.2 2 The pioneering work in this field of study is Hymer (1976). For a good summary of this large body of literature, see Caves (1996)
The studies which have yielded rich insights have their own limitations,one of which arises from the narrow range of host-country variables being used.Most often,these studies incorporate a measure of host-government policies on foreign ownership into their regressions. They mainly approach institutions as determinants of FDI flows rather than as determinants of equity structures.In this type of studies,the common control variables are market size,the export orientation of the economy,infrastructural quality,and political and economic stability.3 While it is natural and commonsensical to include foreign ownership policies in the studies of foreign ownership across countries,there is no need to do so in a study of FDI in China because in the 1990s the FDI policies of China were homogenously liberal. Another limitation related to the use of host-county variables is resulted from the negligence of the fact that FDI policies is just one of the many host-country variables that affect the ownership structures of FIEs.This can be judged by the inconsistent findings of the effect of FDI policies on FDI inflows in empirical studies.Some studies find the effect to be significant while others do not and even have results contrary to anticipation.There are countries which have liberalized the FDI regimes but fail to garner much FDI which others inundated with FDI despite their highly restrictive policies.Taiwan,for example,considerably liberalized its FDI regime in the late 1980s but its FDI/capital formation ratio remained virtually unchanged in the 1990s.India undertook substantial FDI liberalization in the 1990s but its FDI inflows were a fraction of the FDI inflows that went to China,which in fact is quite comparable to India by various FDI liberalization measures.4 3 See the survey by Lim(2001)for more about the findings. 4 Huang(2003)provides a number of such examples. 4
4 The studies which have yielded rich insights have their own limitations, one of which arises from the narrow range of host-country variables being used. Most often, these studies incorporate a measure of host-government policies on foreign ownership into their regressions. They mainly approach institutions as determinants of FDI flows rather than as determinants of equity structures. In this type of studies, the common control variables are market size, the export orientation of the economy, infrastructural quality, and political and economic stability.3 While it is natural and commonsensical to include foreign ownership policies in the studies of foreign ownership across countries, there is no need to do so in a study of FDI in China because in the 1990s the FDI policies of China were homogenously liberal. Another limitation related to the use of host-county variables is resulted from the negligence of the fact that FDI policies is just one of the many host-country variables that affect the ownership structures of FIEs. This can be judged by the inconsistent findings of the effect of FDI policies on FDI inflows in empirical studies. Some studies find the effect to be significant while others do not and even have results contrary to anticipation. There are countries which have liberalized the FDI regimes but fail to garner much FDI which others inundated with FDI despite their highly restrictive policies. Taiwan, for example, considerably liberalized its FDI regime in the late 1980s but its FDI/capital formation ratio remained virtually unchanged in the 1990s. India undertook substantial FDI liberalization in the 1990s but its FDI inflows were a fraction of the FDI inflows that went to China, which in fact is quite comparable to India by various FDI liberalization measures.4 3 See the survey by Lim (2001) for more about the findings. 4 Huang (2003) provides a number of such examples
Apart from FDI policies,another host-country variable frequently used is the "risk"of investing in a particular country.Again,including this variable in a study does make sense; however,the actual effect of political risk can be ambiguous.For example,researchers have theorized that political risks would reduce the incentives of a foreign firm to invest in a particular country and would in turn lead to a decrease of foreign ownership there.Nevertheless, the same political risks faced by foreign firms are also constraints on local firms of the host country.If these political risks pose threats to local firms more than to foreign firms,the latter may increase their ownership of assets in the country.The mechanism that works behind is likely to be that local firms are so constrained and are rendered uncompetitive and thus their assets can be acquired at a low price.> s Some of the existing researches have indeed provided empirical support for the idea that political risks can be associated with greater foreign ownership.For example,in one of the earliest studies that incorporated political risks,Contractor(1990)hypothesizes that lower political risks on the part of the host country should lead to majority equity holdings for US firms.But the regression results contradicted this hypothesis.Similarly,Asiedu and Esfahani(2001)find that better rule of law was in fact negatively correlated with the probability that a US firm would choose a wholly-owned subsidiary(as opposed to a joint venture).They argued that better rule of law may have promoted the productivity of FDI projects,and motivated the host government to seize rent from such projects. But they incorporated an explicit measure ofequity restrictions,which should have already captured the rent- capturing motivations. 5
5 Apart from FDI policies, another host-country variable frequently used is the “risk” of investing in a particular country. Again, including this variable in a study does make sense; however, the actual effect of political risk can be ambiguous. For example, researchers have theorized that political risks would reduce the incentives of a foreign firm to invest in a particular country and would in turn lead to a decrease of foreign ownership there. Nevertheless, the same political risks faced by foreign firms are also constraints on local firms of the host country. If these political risks pose threats to local firms more than to foreign firms, the latter may increase their ownership of assets in the country. The mechanism that works behind is likely to be that local firms are so constrained and are rendered uncompetitive and thus their assets can be acquired at a low price.5 5 Some of the existing researches have indeed provided empirical support for the idea that political risks can be associated with greater foreign ownership. For example, in one of the earliest studies that incorporated political risks, Contractor (1990) hypothesizes that lower political risks on the part of the host country should lead to majority equity holdings for US firms. But the regression results contradicted this hypothesis. Similarly, Asiedu and Esfahani (2001) find that better rule of law was in fact negatively correlated with the probability that a US firm would choose a wholly-owned subsidiary (as opposed to a joint venture). They argued that better rule of law may have promoted the productivity of FDI projects, and motivated the host government to seize rent from such projects. But they incorporated an explicit measure of equity restrictions, which should have already captured the rentcapturing motivations