The Benefits of FDI in a Transitional Economy: The Case of China

China is one of the most popular investment destinations in the world. Throughout much of the 1990s, China accounted for 50 percent of foreign direct investment (FDI) going into developing countries and in recent years, China has been the second largest recipient of FDI in the world, after the United States. The agreements between China on the one hand and the United States and the European Union on the other hand over China’s accession into the World Trade Organization (WTO) may increase China’s already impressive FDI inflows significantly. According to a forecast by Goldman Sachs, in three to four years, China’s WTO membership could boost FDI to 100 billion dollars a year, from the current 40.4 billion dollars. Despite the huge FDI inflows into China every year, both the dynamics driving up FDI inflows and the economic effects of FDI are not well understood. Many of the conventional explanations, such as ones emphasizing FDI as a form of capital import or as a mechanism to transfer know-how, do not fit well with China when applied to the case of China. This paper first presents some of the salient characteristics of FDI inflows into China and then discusses the benefits associated with such a large volume of FDI inflows. The main point of this paper is that the contribution of FDI inflows mainly arises from the fact that FDI inflows overcome or attenuate some of the fundamental inefficiencies in the Chinese economy. Furthermore, FDI has played a substantial efficiency-improving function in large part because the Chinese government itself is unwilling to adopt those internal reforms, such as privatization and regulatory reforms, that will tackle the sources of these inefficiencies directly. Much of this paper is based on my forthcoming book, Selling China: Foreign Direct Investment during the Reform Era (New York: Cambridge Universit