Sizing up Foreign Direct Investment in China and India

Like many other developing countries, China (and later India) has made the remarkable transformation from being hostile to foreign direct investment (FDI) in the 1970s to eagerly attracting it since 1980. China and India make an interesting comparison: China a super-magnet for FDI, while India lagging seriously behind. The two countries also share some common features: Both have high levels of corruption and red tape which may have reduced their FDI. This paper addresses three related questions regarding the size of the inward FDI. First, how important are various dimensions of the business environment (including tax, corruption and red tape) that affect a host country’s ability to attract FDI? (Answer: They are important.) Second, does China’s apparently large magnitude of inward FDI make it an exceptional host? (Answer: No. China in fact is an under-achiever as a host of FDI from the major source countries.) Third, can improvement in the business environment help China (and India) to significantly increase the magnitude of the inward FDI? (Answer: Even though it may be surprising, if China (and India) can manage to seriously address the problems of corruption and red tape, China can probably double the size of FDI from the U.S., United Kingdom and other major source countries.) There is a more general message for development economics and for theories of multinational firms. Although the discussion on FDI often focuses on cheap labor and tax benefits as important determinants, this paper argues that the quality of public governance (e.g., corruption and red tape) of the host countries are also important, if not more important, determinants of international direct investment.