Essays on Foreign Investment, Agglomeration Economies, and Industrial Policy

Since opening its economy to the outside world in late 1978, China has experienced a massive, protracted, and unexpected economic upsurge, which has attracted the attention of a large and diverse group of researchers. China's three-decade economic reforms have reshaped the economic structure from plan to market, through a variety of policy actions, such as openness to foreign investment and efforts to build economic zones. Economic growth and potential technology transfer are indeed the main rationale behind the Chinese government's aggressive efforts over the past three decades to enhance openness and to increase domestic competition. This dissertation consists of three chapters. All chapters study firm behavior and their policy implications. However, the focus of each chapter is different. The first chapter (coauthored with Ann Harrison and Gary Jefferson) studies how institutions affect productivity spillovers from foreign direct investment (FDI) to China's domestic industrial enterprises. The second chapter separates the effect of agglomeration economies on firm performance (measured by total factor productivity) from the impact of competition and better transport infrastructure. The third chapter (coauthored with Philippe Aghion, Mathias Dewatripont, Ann Harrison, Patrick Legros) tests for the complementarity between competition and industrial policy.The first Chapter (co-authored with Ann Harrison and Gary Jefferson) investigates how institutions affect productivity spillovers from foreign direct investment (FDI) to China's domestic industrial enterprises during 1998-2007. We examine three institutional features that comprise aspects of China's "special characteristics": (1) the different sources of FDI, where FDI is nearly evenly divided between mostly Organization for Economic Co-operation and Development (OECD) countries and Hong Kong (SAR of China), Taiwan (China), and Macau (SAR of China); (2) China's heterogeneous ownership structure, involving state- (SOEs) and non-state owned (non-SOEs) enterprises, firms with foreign equity participation, and non-SOE, domestic firms; and (3) industrial promotion via tariffs or through tax holidays to foreign direct investment. We also explore how productivity spillovers from FDI changed with China's entry into the WTO in late 2001. We find robust positive and significant spillovers to domestic firms via backward linkages (the contacts between foreign buyers and local suppliers). Our results suggest varied success with industrial promotion policies. Final goods tariffs as well as input tariffs are negatively associated with firm-level productivity. However, we find that productivity spillovers were higher from foreign firms that paid less than the statutory corporate tax rate. The second chapter separates the effect of agglomeration economies on firm performance (measured by total factor productivity) from the impact of competition and better transport infrastructure. Consequently, this paper primarily addresses the problem of omitted variable bias in estimating the impact of agglomeration economies on firm performance. The results suggest that firm productivity is improved only by the presence of other firms in the same sector (localization economies). The inclusion of information on road construction does not affect the importance of pure localization economies. However, including a measure of competition in the estimation significantly reduces the importance of localization externalities. The results also suggest that both road-building and competition are positively associated with productivity growth. The results for sub-samples indicate that exporting firms and firms financed by foreign investment benefit more from localization externalities than do their non-exporting and domestically-financed counterparts. The third chapter (co-authored with Philippe Aghion, Ann Harrison, Mathias Dewatripont, and Patrick Legros) argues that sectoral state aid tends to foster productivity, productivity growth, and product innovation to a larger extent when it targets more competitive sectors and when it is not concentrated on one or a small number of firms in the sector. A main implication from our analysis is that the debate on industrial policy should no longer be for or against having such a policy. As it turns out, sectoral policies are being implemented in one form or another by a large number of countries worldwide, starting with China. Rather, the issue should be on how to design and govern sectoral policies in order to make them more competition-friendly and therefore more growth-enhancing. Our analysis suggests that proper selection criteria together with good guidelines for governing sectoral support can make a significant difference in terms of growth and innovation performance. Yet the issue remains of how to minimize the scope for influence activities by sectoral interests when a sectoral state aid policy is to be implemented. One answer is that the less concentrated and more competition-compatible the allocation of state aid to a sector, the less firms in that sector will lobby for that aid as they will anticipate lower profits from it. In other words, political economy considerations should reinforce the interaction between competition and the efficiency of sectoral state aid. A comprehensive analysis of the optimal governance of sectoral policies still awaits further research