Research Paper No. 2008/94 Foreign Direct Investment and Regional Inequality in China

China’s economic miracle over the past three decades has been featured with its open-door policy, especially the absorption of foreign capital. One downside effect of economic reform has been the ever rising interregional inequality. As FDI is highly unevenly distributed across regions, many scholars and policymakers have blamed their inflows as one of the main factors driving the Chinese regions apart. If this logic were true, then controlling the scale of FDI could be a solution to reduce regional inequality. However, it is difficult to reconcile the positive effect of FDI on economic growth with its potential ‘negative ’ effect on regional inequality. This is a controversial and provocative issue in the economic development literature. Using the largest panel dataset covering all the Chinese regions over the entire period 1979-2003 and employing an augmented Cobb-Douglas production function, this paper proves that FDI has been an important factor responsible for regional growth differences in China. However, it suggests that FDI cannot be blamed for causing regional inequality; it is the uneven distribution of FDI instead of FDI itself that has caused regional growth differences. The key policy issue is that FDI should be guided towards the inland areas with preferential policies in order to improve the spatial allocation of investments as a means to reduce regional inequality