A Political Cycle of Regional FDI Spillovers in an Emerging Market: Evidence from China.

Author:Li, Can
Position:RESEARCH ARTICLE - Foreign direct investment - Report

1 Introduction

Many governments of emerging economies have put much emphasis on attracting foreign direct investment (FDI), with the belief that FDIs play an important role in stimulating local economic growth (Blomstrom 1986; Caves 1974; Delios and Henisz 2003; Meyer and Nguyen 2005; Sinai and Meyer 2004). Meanwhile, promoting knowledge spillover from FDIs should also serve as an important goal for government, since the ultimate purpose of FDI attraction is to promote local economic development through bringing in advanced technological and managerial knowledge. Therefore, understanding how government shapes the FDI spillover mechanisms delivers important practical implications for both policy makers and firms involved in the process.

The issue, however, has received limited attention in current literature. Targeting at reconciling the mixed empirical evidences regarding the effects of FDI presence on domestic productivity (Aitken and Harrison 1999; Blomstrom 1986; Buckley et al. 2002; Caves 1974; Kokko 1996; Zhang et al. 2014), researchers have been devoted to identifying contingency factors for the spillover mechanism (Aitken and Harrison 1999; Blomstrom 1986; Buckley et al. 2002; Tian 2007). This stream of research has predominantly examined the contingency of heterogeneous features of domestic firms and foreign firms (Buckley et al. 2002, 2007; Liu et al. 2000; Zhang et al. 2010). Recent studies have also examined how FDI spillover effects are influenced by specific attributes of formal institutions, for example, host country's governance infrastructure (Globerman and Shapiro 2003), intellectual property rights (IPR) protection (Smeets and de Vaal 2016), and subnational institutional development level (Xiao and Park 2018). However, these studies have largely neglected the roles of the agents (i.e., politicians) in influencing the FDI spillover effect. As a matter of fact, politicians may have varying interests and policy preferences at different stages (Bonardi et al. 2005). In response to such research gap, we examined how the turnover of local political leader, which is a key dynamic event occurring in political environment, shapes the regional competition and learning dynamics between foreign firms and domestic firms in the same industry.

As informed by the political business cycle (PBC) literature, macroeconomic conditions change corresponding to the turnover of political leaders, because incumbent political leaders are incentivized to adopt specific policies in line with their partisans (Alesina et al. 1997; Hibbs 1977) or opportunistically manipulate regional policies to enhance their election advantages (Nordhaus 1975). Related studies have shown empirical evidences that there are political cycles of municipal spending (Veiga and Veiga 2007), employment (Labonne 2016), foreign aid (Faye and Niehaus 2012), international cooperation (Cazals and Sauquet 2015) and other business aspects. Our research is embedded in China, which is the largest FDI recipient country among emerging markets. Local governments are deeply involved in economic activities, and possess high degree of economic autonomy. More importantly, evaluation and promotion of local political leaders are based on their performance in promoting local economic growth. Politicians are thus engaged in a promotion competition with peer politicians in the same level (Li and Zhou 2005), and have strong incentive to promote economic growth as soon as the start of their term. Such motivation is reflected in strengthened governmental efforts in promoting and facilitating positive FDI spillovers to domestic firms following the calendar year in which the political turnover occurs. Using data on political turnovers at municipal cities of China and a large sample of industrial companies spanning across 1998 and 2007, our arguments received significant support. We found that domestic firms benefit more from FDI spillovers following the turnover of local political leaders. The effect is also stronger when the newly appointed political leader is a native politician, and for state-owned enterprises (SOEs).

Our study makes three important contributions to the prior literature. First, we identified a novel contingency factor from political environment, i.e., the turnover of local political leader, which exerts profound influence on FDI spillover dynamics. The study echoes the call for more studies into interactions between MNEs and local institutional environment (Eapen 2012; Meyer 2004; Spencer 2008). Political environment, as a key dimension of institutional environment, was considered as a critical factor in shaping firms' choices of strategy and performance outcomes (Delios and Henisz 2003; Henisz 2000). However, the empirical study that directly examines how local political conditions may alter the interactive relationships among foreign and domestic firms remains scarce. The issue is especially critical in emerging countries like China, where subnational governments are deeply involved in economic activities, and are highly autonomous in governing economic development. Second, we extended the literature of political business cycle to a new country with unique political institutions (Guo 2009). Our study was embedded in Chinese context, where politicians are managed and evaluated under the control of a single ruling party. We again revealed that FDI spillover effects are contingent on the turnover of political leaders, which we refer to as a political cycle of FDI spillovers. Third, this study also contributes to the literature of subnational institutional environment (Chan et al. 2010; Ma et al. 2013; Meyer 2004). Subnational political environment is critical for understanding FDI spillover dynamics since regional policy maker can influence to what extent local firms benefit from MNE presence through manipulating the local regulatory regime (Meyer 2004). The literature of subnational institutions reports significant impact of subnational institutional environment on MNE operation, and emphasizes local political conditions as an important underlying dimension (Chan et al. 2010; Ma et al. 2013). However, few studies have provided direct examination on subnational political environment. Our study addressed this gap through examining how turnovers of local political leaders alter the magnitude of FDI spillovers effects on domestic businesses at regional level.

2 Theoretical Background and Research Context

2.1 Spillovers Effects of FDI

Foreign direct investment exerts profound externality influences on domestic firms. In the context of emerging economies, the presence of MNEs holds the potential to help increase productivity of domestic firms by providing advanced technological and managerial knowledge, forming positive spillover effects of FDI. However, the spillover effects could also be negative. As strong competitors for market and resources, MNEs are equipped with the capability to compromise the competitive advantages of domestic firms, and even hurt their likelihood of survival (Chang and Xu 2008; Spencer 2008).

According to the literature, the externality influences of intra-industry FDI are realized through four core mechanisms (Meyer 2004; Spencer 2008; Zhang et al. 2014). The first is demonstration effect. Investment by MNEs enabled domestic firms to observe and emulate advanced technologies, business practices and strategies of foreign competitors. The vicarious learning process leads to increased productivity of domestic firms. The second is linkage effect. Collaborative linkages between MNEs and domestic firms facilitate the spillover of knowledge, and motivate practice improvements of domestic firms through exposing them to demanding standards of product and services by MNEs (Markusen and Venables 1999; Rodriguez-Clare 1996). The linkage effect could also turn negative, when MNEs are able to lock in the best partners, and force domestic firms to shift to inferior choices (Spencer 2008). The third is mobility effect, which is also a double-edged sword for domestic firms. On one hand, training of local employees by MNEs enables knowledge spillover when these employees move to domestic firms. On the other hand, domestic firms could be crowded out when MNEs are able to pay higher wages and hire away the best labor supplies available in the market (Meyer 2004; Spencer 2008). The fourth is competition effect. Again, the effect could be positive, when competitive pressure from MNEs stimulates local firms to reduce slack resources and upgrade technologies. The effect turns negative, however, when the pressure becomes too strong for domestic firms to handle.

To sum up, FDIs exert both positive and negative spillover effects on domestic firms. Such theoretical intricacy is reflected by the mixed empirical results regarding this issue. Extant studies reported positive (Blomstrom 1986; Buckley et al. 2002; Caves 1974; Zhang et al. 2014), insignificant (Haddad and Harrison 1993; Kokko et al. 1996), as well as negative (Aitken and Harrison 1999) effects of FDI presence on domestic firms' productivity. Facing the mixed evidences, recent studies have explored the contingency factors for FDI spillover effects. In this vein of research, studies have mostly employed a learning- or resource-based perspective, and identified various firm- and industry- factors that accelerate or impede knowledge acquisition of domestic firms. For example, the literature suggests that absorptive capacity of domestic firms (Buckley et al. 2002; Liu et al. 2000), FDI ownership characteristics (Buckley et al. 2007; Chang and Xu 2008), FDI country origin diversity (Zhang et al. 2010), as well as FDI entry tenure (Zhang et al. 2014) significantly affect the magnitude of spillover effects. Recently scholars start to turn their attention to the contextual issues of FDI spillovers. For example, Yi et al. (2015) examined how regional institutional characteristics, such as...

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