Entry Mode and Location of Foreign Manufacturing Enterprises in China

Entry Mode and Location of Foreign Manufacturing Enterprises in China Canfei He1

Abstract: Foreign investors in China may choose between three modes of entry: equity joint ventures (EJVs), contractual joint ventures (CJVs), or wholly foreign owned enterprises (WFOEs). Those entry modes vary considerably in their legal forms, risk characteristics, resource commitments, and investment motivations. This paper evaluates and compares their locational patterns, and reveals similarities and differences in their locational behaviors. A regression model is developed to explain the distinctive locational patterns of these modes of entry, providing results that may serve both to guide locational decisions of potential investors, and provide scientific support for local governments in designing FDI policies. Journal of Economic Literature, Classification Numbers: F21, F23, R30. 5 figures, 3 tables, 40 references.

INTRODUCTION

T

he massive flows of foreign direct investment (FDI) into transitional China have recently attracted a great deal of attention in the fields of business, economics, and geography. Many studies have focused on FDI locations only at the aggregate level, and have highlighted the importance of traditional factors, such as market size, labor costs, economic growth, and transportation linkages (Leung, 1990; Gong, 1995; Chen, 1996; Head and Ries, 1996; Broadman and Sun, 1997; Wei et al., 1999; Cheng and Kwan, 2000; Coughlin and Segev, 2000; He, 2002). Foreign direct investments in China, however, are rather diversified. Foreign investors, for instance, may enter China through three dominant entry modes: equity joint ventures (EJVs), contractual joint ventures (CJVs), or wholly foreign owned enterprises (WFOEs). Those modes differ substantially in terms of their legal forms, risk characteristics, resource commitments, and investment motivations. Their locational behaviors are also expected to be considerably different. To date, the existing literature has ignored the influence of entry modes on FDI locations in China. However, an understanding of the distinctive locational patterns of EJVs, CJVS, and WFOEs may not only guide the locational decisions of potential investors, but provide scientific support for local governments to designate FDI policies. This paper attempts to evaluate and compare the locational behaviors of EJVs, CJVs, and WFOEs based upon data compiled from the most recent industrial census of China in 1Department of Urban and Regional Planning, College of Environment Sciences, Peking University, Beijing, 100871, People’s Republic of China. Email: [email protected]. Special thanks go to Professor Cindy Fan for her constructive suggestions. The author is also indebted to Professor Breandan O’hUallachain and two anonymous reviewers for their insightful comments and suggestions. Any remaining errors are those of the author. The research is supported by project 40271035 funded by National Natural Science Foundation of China.

443 Eurasian Geography and Economics, 2003, 44, No. 6, pp. 443-461. Copyright © 2003 by V. H. Winston & Son, Inc. All rights reserved.

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1995. Empirical results indicate that the EJVs are more dispersed in space than the other two modes, with CJVs being the most spatially concentrated mode. WFOEs largely are concentrated in the Pearl River Delta, the Chao-Shan Area, the Yangtze River Delta, Beijing, Tianjin, and the coastal province of Fujian (Fig. 1). Further analysis reveals both similarities and differences in the locational determinants of EJVs, CJVs and WFOEs. Regardless of their entry modes, foreign manufacturing enterprises are drawn to the clusters of foreigninvestment enterprises and industrial activities, indicating the critical role of scale economies in FDI locations. The temporal and spatial processes of economic transition also influence the location of foreign enterprises in space. The most noteworthy differences exist between JVs and WFOEs. Compared to JVs, WFOEs are more likely to be sited in cities that host many foreign enterprises and have developed strong industrial bases. As the most risky entry mode, WFOEs also show a stronger tendency to concentrate in cities that have demonstrably benefited from China’s Open Door Policy2 and economic transitions, and to cut production costs by locating in areas of low labor cost. Good domestic market accessibility is a significant attraction for EJV start-ups but not for new CJVs or WFOEs, which is consistent with the distinctive investment motivations and legal requirements of each mode. FOREIGN ENTRY MODES IN CHINA Equity Joint Ventures An EJV is a limited liability firm incorporated and registered in China. Capital is contributed from both the foreign and local partners, who hold shared equities. It is treated as a distinct legal business entity subject in all aspects to Chinese laws and administrative procedures. Both partners are responsible for costs and divide profits in negotiated proportions (Wang, 1997). The Law of the PRC on Sino-Foreign Joint Ventures promulgated in July 1979 and revised in 1990 set forth the primary legal framework for EJVs. Its detailed Implementation Act was enacted in September 1983. The EJV law specified that China permits foreign companies, other economic entities, or individuals to incorporate themselves in the territory of China into joint ventures with Chinese companies or other economic entities. While the EJV law sets a minimal foreign equity contribution of 25 percent, there is no upper limit. The foreign party can thus contribute up to 100 percent (Wang, 1997). A JV is encouraged to market its products outside of China. The EJV Implementation Act provides more specific guidelines concerning a JV’s operations in terms of market access, management autonomy, and taxation (Fu, 2000). A JV is allowed to sell domestically under the EJV Implementation Act. A JV’s enterprise income 2China’s economic transition is best described as a gradualist approach. Following the enactment of the Equity Joint Venture Law in the late 1979, China established four special economic zones (SEZs) in Guangdong and Fujian provinces to experiment with the development of market-oriented economic systems and to encourage an influx of foreign production, technology, and management skills. The Chinese government further opened 14 coastal port cities in 1984 and established several open economic zones in the coastal region, including the Pearl River Delta, Yangtze River Delta, the coastal Fujian zone, Eastern Liaoning, and the Shandong Peninsula by 1988. Further expansion of the Open Door Policy made Hainan island the largest special economic zone. In 1992, the Chinese government launched another major drive to open all inland provincial capitals, six major cities on the Yangtze River, and 13 border cities in southwestern and northern China to attract foreign investment. All of these open zones have adopted special policies to encourage foreign investment. This staged, gradual Open Door Policy has provided the coastal region with significant policy advantages.

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Fig. 1. Chinese administrative provinces and key regions.

tax is set at 30 percent, which is about 20 percent lower than that for domestic firms. There is additional tax relief if certain conditions are met (Wang, 1997). For example, the enterprise income tax for manufacturing foreign enterprises in Special Economic Zones (SEZs) or Economic and Technological Development Zones (ETDZs) is set at 15 percent. From the very beginning of the Open Door Policy, EJVs have enjoyed a better legal base compared to other modes. Furthermore, China considers EJVs to be the preferred mode of FDI, believing that they will not only bring foreign capital, technology, and managerial skills, but also allow a considerable degree of control over domestic enterprises (Pearson, 1991). The EJV mode also has certain advantages from the investor’s point of view, as foreign investors entering a country with different cultural, political, and economic systems from their own are likely to seek cooperative arrangements with local firms (Dunning, 1993). In transition economies, where requirements for adaptation and information are greater due to market imperfections, the appropriateness of a EJVs is further reinforced (Beamish and Banks, 1987). It is therefore not surprising that EJVs are the preferred mode of operation in China among foreign investors from North America and Western Europe (Sun, 1999). Nokia, for instance, has established several equity joint ventures to supply mobile phones and mobile and fixed telecommunication networks in Beijing, Shanghai, and Chongqing since 1994. Many American business giants like Hewlett Packard, IBM, Motorola, General Motors, General Electric, Ford, and McDonald’s have established several joint ventures in

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China as well (Luo, 2000). The most commonly cited motives for selecting the EJV mode include the opportunity to gain rapid market entry, exploit economies of scale, obtain local know-how and vital raw materials, spread business risks, and meet host government demands (Dunning, 1993). Local partners may help foreign firms gain access to marketing channels and assist in obtaining location-specific knowledge concerning policies, business practices, and operating conditions, as well as in hiring labor, accessing capital, and purchasing or leasing land. With the help of local partners, EJV investors may face lower external uncertainties and business risks. Given the lengthy period of existence of this mode, and China’s positive attitude toward joint ventures, EJVs afford more flexibility than the other modes in selecting locations for operation, and make it easier to penetrate China’s inland regions. EJVs, however, may pose challenges in production and management, inasmuch as their performance depends on successfully blending the partners’ different organizational cultures, administrative styles, and management philosophies (Walsh et al., 1999). An example is the experience of the Beijing Jeep venture, rife with contentious wrangling between joint venture partners regarding employment levels and bonus distributions that almost terminated the business (Mann, 1989). Moreover, EJVs afford great potential for opportunistic behavior by each partner. Furthermore, protecting property rights becomes difficult in EJVs, particularly in transition economies with weak intellectual property laws (Luo and Chen, 1995). As the FDI regulatory frameworks are improved, and institutional uncertainties gradually diminish, foreign investors may desire to maintain full control of their investments and favor WFOEs. Contractual Joint Ventures CJVs are arrangements whereby Chinese and foreign partners cooperate in certain joint project activities according to the terms and conditions stipulated in a venture contract (Wang, 1997). CJVs are used mostly for lower-value-added export-processing operations. They appeared at the same time as EJVs after China’s first Joint Venture Law was promulgated in 1979. In fact, CJVs were the dominant mode during the early years. Initially, CJVs were governed largely by the laws and regulations promulgated for EJVs, inasmuch as there were no separate laws governing this mode of investment. A CJV law eventually was promulgated in April 1988 and the CJV Law Implementation Act was enacted in September 1995 (Fu, 2000). The CJV law provided that when establishing contractual enterprises, the Chinese and foreign parties shall, in accordance with the regulations of this Law, specify the cooperation conditions, the distribution of the profits or products, the share of risks and losses, the method of management, the ownership of the properties of the enterprises when the cooperation ceases, and other issues covered in the cooperative enterprise contracts (Wang, 1997). The major advantage of this mode is the flexibility of both partners to form a joint venture based on their common interests and needs. Although both are joint ventures, CJVs and EJVs are substantially different. First, a CJV is regulated by a less strict legal regime and does not have to be a distinct Chinese legal business entity, which clearly imposes greater business uncertainties and risks on foreign parties than EJVs. Second, the corporate structure of CJVs is more flexible and can be based on: (1) a board of directors; (2) a joint committee consisting of representatives of the parties involved; or (3) by entrusting daily managerial tasks to a third party. Finally, a CJV enjoys more freedom in terms of financing. Capital contributions to a CJV may be in the form of cash, buildings, facilities, machinery, industry property rights, or trademarks. They may also be in the form of natural resource rights and labor, which is not permitted for an EJV.

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Non-cash components do not necessarily have to be factored into a CJV, as is mandatory for an EJV. Furthermore, there is no minimum foreign equity requirement for a CJV, which allows foreign investors to set up a joint venture with only a small investment for a quicker return. CJVs are very popular among overseas Chinese investors, especially those from Hong Kong, since a CJV has no legal or regulatory hurdles to overcome in transferring the management of the joint ventures to their friends or relatives (Fu, 2000). When foreign investors anticipate a situation of tenuous property rights and other institutional uncertainties, CJVs would be the logical mode. As China’s FDI regulatory framework gradually matures and becomes more reliable, it is expected that fewer CJVs will be established. Nike, for example, initially entered China by establishing CJVs with state-owned factories. This entry mode proved to be unsuccessful for Nike, because the state-owned factories cold not comprehend what Nike wanted in terms of price, quality, and delivery, and its China operations posed a heavy financial burden. Nike gradually scaled back relations with state-owned factories and its last contract with a state firm ended in 1989, the year one of Nike’s major agents set up a Hong Kong unit to invest in Chinese footwear producers (Luo, 2000). Wholly Foreign-Owned Enterprises Initially, the WFOE mode was not permitted except as policy experiments within the SEZs. Expansion of this mode to other areas occurred only in the late 1980s, when the Law of the People’s Republic of China on Wholly Foreign-Owned Enterprises was promulgated in April 1986 (Wang, 1997). The WFOE law stipulated that China would allow foreign investors to establish foreign capital enterprises in country. It also specified that the property rights of WFOEs would be protected by the state, that foreign investors could repatriate profits earned in China, and that such investors were entitled to any residual funds if a WFOE were to be liquidated. The Law specifically prohibits the state from nationalizing or expropriating WFOEs (Wang, 1997). However, the WFOE Implementation Act was not enacted until four years later (1990). Therefore, there was a lengthy period of uncertainty during which WFOEs operated in China on a rather ad hoc basis and were treated differently in different locales, which obviously deterred foreign investors from selecting this mode (Fu, 2000). The WFOE Law considers a wholly foreign-owned enterprise as a limited liability company established in China with capital contributed exclusively by foreign investors. Compared to JVs, WFOEs enjoy some critical advantages. A WFOE may rely on its parent company’s globally integrated market networks to reduce vulnerability to local environments. WFOEs also are more flexible and independent in managing production, financing, and marketing decisions and can enhance control over local operations, avoiding partners’ opportunism and protecting proprietary company information in an environment where an intellectual property rights system is not well established (Luo, 1998; Fu, 2000). Facing great political uncertainty and desiring to maintain full control over their business operations, Taiwanese investors, for example, have exhibited a strong preference for WFOEs in Mainland China (Sun, 1999; Fu, 2000). Fu (2000), for instance, reported that about 80 percent of Taiwanese investment in Fujian is in the WFOE entry mode. WFOEs, however, involve higher operational hazards, greater financial costs, and more organizational commitments (Beamish et al., 1987). The hazards and costs of WFOEs are further magnified by the regulatory uncertainties, institutional hostilities, and contractual hazards encountered by foreign investors in transitional economies (Shan, 1991; Pan, 1996).

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Unlike participants in JVs, WFOEs investors are unable to count on experienced local partners to gather local market intelligence, deal with public relations, and maneuver through the bureaucracy, thus increasing information and transaction costs. Furthermore, compared to JVs, WFOEs face greater sectoral restrictions and performance requirements. WFOEs are prohibited from operating in such sectors as the media, retail and wholesale, and telecommunications. WFOE investors need direct approval from the central government to make investments in public utilities, transportation, real estate, trusts, and leasing. For a WFOE to be approved, it must also satisfy statutory performance requirements: apply advanced technology, develop new products, contribute to import substitution, or else export more than 50 percent of the value of their output(Wang, 1997). These requirements are theoretically nonnegotiable even though they are not enforced rigorously in practice (Fu, 2000). Furthermore, when the WFOE Law was first published in 1986, there was no explicit tax concession for WFOEs, which were required to pay taxes in accordance with the Foreign Enterprise Income Tax Law of 1982. Under this law, the enterprise income tax for WFOEs was charged at a progressive rate from 20 percent up to 40 percent, plus a possible 10 percent local tax surcharge, thus bringing the overall tax levy to a maximum of 50 percent. As a result, WFOEs paid higher taxes than JVs until the Unified Tax Law was passed in 1991, which treated all forms of FDI equally for tax purposes (Fu, 2000). Overall, among the three entry modes, WFOEs face the most restrictions and encounter the highest risk associated with institutional uncertainties. When an environment is opaque, unreliable, and capricious, foreign investors would less likely choose the WFOE mode. As institutional uncertainties recede and legal environments become more favorable to foreign investors, more WFOEs would be expected since they enjoy greater flexibility and independence in their business operations and could more easily protect their property rights. Luo (2000), for example, reported that many major multinational corporations from the West have started to establish WFOEs since the 1990s in China. Motorola established a wholly owned venture, Motorola (China) Electronics, in Beijing and a wholly owned manufacturing facility in Tianjin in 1992. Approximately 10 years after Hewlett Packard entered China, it launched its first wholly owned operations. IBM desired to exert control over its operations, and has recently established a few wholly owned companies (Luo, 2000). As economic transition proceeds, China increasingly has become integrated with the global economy and institutional uncertainties have gradually receded. Multinationals also have gained business experience in the Chinese economy. Foreign entry modes therefore have evolved from an initial focus on risk-averse forms such as joint ventures to more aggressive wholly foreign-owned enterprises. Figure 2 depicts temporal changes in the entry modes of FDI in China between 1983 and 2002. CJVs were the dominant entry mode before 1985 due to their less stringent legal requirements, greater flexibility, and quicker return on investment. Because of the absence of a clear and independent legal form and less favorable policy treatment by the Chinese government, CJVs subsequently have declined steadily. EJVs replaced CJVs as the dominant mode in the second half of the 1980s and dominated FDI until 1999. After a very tentative appearance in the first part of 1980s, WFOEs have gradually and constantly improved their status since promulgation of the WFOE Law in 1986 and enactment of the WFOE Implementation Act in 1990. Surpassing CJVs in 1990 and EJVs in 2000, WFOEs are currently the most important entry mode for foreign investment in China. The steady and incremental increase in WFOEs implies that investors have improved their abilities to reduce contextual hazards and mitigate operational uncertainties as a result of learning and experience over time. The dramatic change of FDI entry modes is also the result of gradually improved and liberalized FDI regulatory framework in China.

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Fig. 2. Structural changes of foreign entry modes in China, 1983–2002.

Empirical Investigation of the Choice of Foreign Entry Modes A number of studies have investigated the factors affecting foreign investors’ selection of an entry mode into the Chinese market. Hu et al. (1993), for instance, reported that social-cultural distance, economic hazards, and R&D intensity have the potential to influence foreign equity ownership. Zhao and Zhu (1998) and Chadee and Qiu (2001) documented that the duration and scale of international joint ventures are positively associated with the level of foreign ownership. Industry-specific factors, such as skill level, market concentration, market potential, and foreign business agglomerations also influence the ownership preference of foreign firms (Zhao et al., 1998). Sun (1999) further determined that foreign equity shares tended to increase in tandem with the technological intensity of investment projects and liberalization of the economic environment. Interestingly, most previous studies also have observed that the entry modes of foreign projects also are significantly affected by where they are located (Shan, 1991; Hu and Chen, 1993; Pan, 1996; Tse et al., 1997; Zhao and Zhu, 1998; Sun, 1999; Chadee and Qiu, 2001). Pan (1996) and Sun (1999), for instance, claimed that foreign partners were more likely to acquire a higher ownership share when the projects were located in either southern China or the three municipal cities of Beijing, Shanghai, and Tianjin. No studies, however, have systematically examined those location-specific factors. The empirical questions of whether and why different foreign entry modes favor distinct locations remain unanswered. DATA SOURCE AND MODEL Data Sources The limited availability of micro-level data has restricted the disaggregated investigation of foreign manufacturing investments in China. The release of the Third National Industrial Census of the People’s Republic of China 1995 (State Statistical Bureau, 1997), however,

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provides a unique data set on foreign enterprises. This is the most recent industrial census that permits a variety of disaggregated analysis of foreign manufacturing enterprises at the level of individual cities. This data set covers all foreign manufacturing enterprises with independent accounting systems in 1995. Detailed information for individual enterprises was provided by this data set, such as location, starting year,3 country of origin, entry mode, and sectors. This study focuses on those enterprises established between 1992 and 1995, because foreign investors faced fewer sectoral and regional restrictions and the legal regulatory frameworks for all three entry modes had been fairly improved and liberalized during this period. Some 28,521 foreign manufacturing enterprises began operation during this period, including 18,819 EJVs, 2887 CJVs, and 6,815 WFOEs. Other data involved in this study were obtained from the Urban Statistical Year Book of China, 1996 (State Statistical Bureau, 1996) and various issues of the China Statistical Yearbook (State Statistical Bureau, annual, 1985-2002). Modeling the Locational Choices of Foreign Manufacturing Enterprises Many techniques have been applied to model the locations of foreign enterprises, such as multiple regression models, conditional logit models, Tobit models, and Poisson regression models. The number of new foreign manufacturing enterprises locating in a Chinese city is a reasonable candidate for a Poisson distribution, because of the preponderance of zeros and small values and the clearly discrete nature of the dependent variables (Greene, 2000). Based on the Poisson regression model, the likelihood of observing a number of new foreign enterprises yi is: –λi y

e λi i Prob ( Y i = y i ) = ---------------, y i = 0, 1, 2, 3, … y i!

(1)

The parameter λi is assumed to be log-linearly dependent on some explanatory variables, Ln (λi) = β Xi,

(2)

where β is a parameter vector to be estimated and Xi is the vector of urban attributes that influence foreign enterprises’ profits. The log likelihood function for this model is n

LnL =

∑ [ – λi + yi βXi – Ln ( yi! ) ] .

(3)

i=1

The Poisson model, however, imposes the restriction that the dependent variable’s mean and variance equal λi. A simple procedure used for testing the hypothesis of nonexistence of overdispersion is carried out by regressing Zi on either a constant term or λˆ i without a constant term. The t test of whether the coefficient is significantly different from zero tests the null hypothesis (Cameron and Trivedi, 1990; Green, 2000). Zi is defined as ( y i – λˆ i ) – y i Z i = -----------------------------. λˆ i 2 3About

8 percent of foreign enterprises did not report the year their operations began.

(4)

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Table 1. Definitions of Variables and Their Expected Signs Variable

Definition

Expected sign

EJV CJV WFOE PFFE INDU MART PORT TIME ZONE PRIV WAGE

Number of EJVs established between 1992 and 1995 in a city Number of CJVs established between 1992 and 1995 in a city Number of WFOEs established between 1992 and 95 in a city Number of foreign manufacturing enterprises in 1991 in a city Number of industrial enterprises in a city in 1995 Weighted urban market potential in 1995 Being a port city Number of years a city had been open by 1995 A city with policy zones Percentage of non-state urban industrial employment in a city Nominal wage rate adjusted for labor productivity in 1995

+ + + + + + + -

where λˆ i is the predicted value from the Poisson regression. If the regression-based tests show evidence of overdispersion in the Poisson model, the negative binomial regression model, which allows the variance to exceed the mean, will be applied to estimate β. The equation (2) will be modified as follows: Ln(λi) = β Xi + εi.

(5)

Two hundred and eighty two cities in China contained some type of foreign enterprise that was established between 1992 and 1995. To strengthen rural-urban economic linkages, many cities have brought neighboring counties into their administrations since 1983, thus significantly expanding their urban areas. Shiqu, a spatial unit encompassing only the central city and the surrounding suburbs, has proven to be consistent over time, thus allowing temporal comparisons. Furthermore, an urban area’s major economic functions tend to be concentrated in the shiqu (State Statistical Bureau, 1996). This study employs the shiqu as the spatial unit of analysis. Models are now estimated for EJVs, CJVs, and WFOEs, respectively. Independent Variables and Hypotheses The probability that a foreign firm will select a specific city for an investment transaction/enterprise site depends on a set of urban attributes associated with agglomeration economies and economic transition (Table 1). Foreign investors, in particular, appear to benefit from locating in existing clusters of foreign enterprises (Dunning, 1998). Information spillover among foreign investors, backward and forward linkages between multinationals, imitation behaviors of competitive firms, and previous investment experiences may attract additional investments to locations favored previously (Smith and Florida, 1994; Kinoshita and Mody, 2001). Furthermore, clusters of foreign enterprises may signal investment opportunities and good investment environments to investors otherwise not familiar with a particular city, and therefore attract new foreign manufacturers. To test the agglomeration effect, the number of foreign manufacturing enterprises in a city in 1991 (PFFE) is included and the sign associated with its coefficient is expected to be positive. The spatial concentration of industrial activities signals a set of favorable conditions for foreign investors, such as local suppliers, specialized labor forces and services, developed

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infrastructure, and local partners (Smith and Florida, 1994). Links among firms, institutions, and infrastructure within a city give rise to localization economies that are external to individual firms. There is systematic evidence to suggest that foreign subsidiaries are attracted to clusters of economic activities and to closely related industries (Wheeler and Mody, 1992; Head and Ries, 1996; Dunning, 1998; Coughlin and Segev, 2000; Guimaraes et al., 2000; He, 2002, 2003). The number of industrial enterprises in a city (INDU) is introduced as a proxy for industrial agglomeration and a positive relationship is anticipated. Recent research has indicated that interactions between scale economies and transportation costs facilitate the concentration of manufacturing activities in a few large markets (Krugman, 1991). A foreign enterprise’s sales are not confined to a city’s boundaries. An accessibility index is therefore a better measure of a city’s market potential (Gong, 1995). A province’s market potential is defined as the sum that province’s interactions with every other provincial market (including itself). These interactions are proportional to the province’s population size and inversely related to the squared distance of that province to every other province. Zhao and Zhu (2000) introduced a circulating fund turnover ratio (CFTR), calculated by dividing the product sales income by the average balance of circulating capital in a city, to measure a city’s market potential. The higher this ratio, the more the sales income generated. CFTR in its original form is only a good proxy for local market potential. This study weights the provincial market potential using CFTR to create a better measure for a city’s market accessibility (MART), which is defined as follows:  POP MART = CFTR ⋅  -------------i +  D ii2

POP 

j , ∑ ------------2 D ij 

(6)

where POPi and POPj represent, respectively, the total population in province i and j, Dij is the shortest railway distance between the capital cities of province i and j, D ii =

A -----i and Ai π

is the area of province i. Positive coefficients are expected for MART. Location in a port city potentially facilitates firms’ access to the global markets and their chances of profiting from scale economies. Leung (1990) and Gong (1995) have argued that seaports and water transportation provide the primary advantages that have attracted foreign investment to Chinese cities. A dummy variable for port cities, PORT, is included and a positive sign is expected. Foreign investors in transitional economies are confronted with significant operational hazards and uncertainties, as the rules of the game are different from those prevailing in market economies (Luo, 1997). Locations that are able to minimize institutional uncertainties and business risks are therefore favorable to foreign investors. A city’s economy “opening time” (TIME),4 whether it contains or is itself a policy zone (ZONE),5 and the degree of privatization (PRIV) are introduced to test the influence of reforms in China’s economy on the location decisions of foreign firms. The earlier opened cities are expected to attract more foreign enterprises because domestic firms and local government agencies will have gained 4A city’s opening time is the difference between 1995 and the year that government designated the city as an open area for foreign investment and a positive sign is expected. 5Policy zones are areas in which foreign investments are encouraged through tax incentives, import duty reductions, reduced land-use fees, elimination of red tape, and more relaxed labor regulations. They are discussed in more detail in the following paragraph.

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more experience in working with foreign investors, and will have learned how to create an attractive and stable environment for FDI (Tse et al., 1997). Those cities also enjoy a broad range of locational and institutional advantages. China’s FDI regulatory framework has both policy and legislative dimensions, which need to be treated differently. The investment laws, such as the EJV, CJV, and WFOE laws and their auxiliary implementation acts, have evolved over time and are meant to be applied throughout the country. As such, they do not constitute a salient institutional advantage that is location-specific (Fu, 2000). FDI policies, however, are largely location-oriented. China granted a variety of investment incentives to foreign projects located in “policy zones”— special economic zones (SEZs), open coastal cities (OCCs), and economic and technological development zones (ETDZs)—and provincial capitals. For instance, in the policy zones mentioned above the enterprise income tax rate was set at 15 percent or 24 percent. This compares favorably to the 30 percent tax rate for foreign enterprises elsewhere in China. Along with tax incentives, foreign investors are offered import duty reductions, reduced land-use fees, elimination of red tape, and more relaxed rules on labor relation regulations (Wang, 1997). More favorable treatment is accorded to export-oriented and technology-intensive projects. Moreover, governmental and economic institutions in these policy zones also are to take actions supporting foreign investment. A dummy variable, ZONE, is included in the models, having a value of 1 for policy zones and 0 for others, and positive coefficients are expected. Because of China’s transition from a planned to a market-oriented economy, the development of market systems should be a key locational factor (Sun, 1999). Economic liberalization in China is spatially biased, and the degrees to which urban economies are market driven vary significantly. Theoretically, foreign investors will prefer locations with relatively liberalized economies, and a high level of development of non-state enterprises suggests a liberalized environment. The percentage of non-state industrial employment in the total urban employment in a province (PRIV) measures the degree of economic liberalization and is expected to have a positive sign. Finally, labor costs appear to be a central factor influencing FDI location, although there are different views of the precise role of wage rates in FDI location. Cheng and Kwan (2000), Coughlin and Segev (2000), and He (2002) found that higher wage rates discourage FDI, whereas Broadman and Sun (1997), Chen (1996), and Head and Ries (1996) did not report a significant relationship. Zhao and Zhu (2000), on the other hand, found a positive relationship. Perhaps these differences are associated with the way labor productivity is handled in the different studies. A lower wage rate is not attractive if it is associated with lower labor productivity. In this study, the average wage rate divided by GDP per worker in a city (WAGE) is used as a measure of real labor costs, and the relationship is expected to be negative (i.e., the lower the real labor cost, the greater the attractiveness for FDI). EMPIRICAL RESULTS Spatial Distribution of Foreign Manufacturing Enterprises To compare the locational patterns of foreign manufacturing enterprises, the dissimilarity index (ID) is computed:

∑

Pi – Ii I D = -------------------------- , 2

(7)

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Fig. 3. Distribution of urban equity joint ventures (EJVs).

where Pi and Ii represent the urban percentages of two distributions, respectively. If the two spatial distributions are identical, ID equals zero; if they are completely different, ID is 100. The ID index for EJVs/CJVs is 50.33 while that for EJVs/WFOEs is 42.43. Comparing CJVs and WFOEs generates an even larger dissimilarity index of 50.46. These results show that the three entry modes have substantially different spatial patterns. Using the above equation, it is also possible to calculate a relative concentration coefficient for each entry mode, by comparing their spatial distribution to that of all foreign manufacturing enterprises. A larger coefficient indicates a more concentrated spatial pattern. The relative concentration coefficients for EJVs, CJVs, and WFOEs are 13.92, 44.08 and 29.44, respectively, which implies that CJVs are the most concentrated in space and EJVs are more spatially dispersed than the other two modes. Maps of the urban distributions of EJVs, CJVs, and WFOEs show where they are concentrated. Overall, the coastal cities are the most favorable locations for all types of foreign manufacturing enterprises. EJVs (Fig. 3) are widely dispersed from the coast to the central part of the country, and are visible even in major cities in relatively more remote areas, such as the provinces of Sichuan, Shaanxi, Inner Mongolia, and Gansu. This is largely due to the institutional support EJVs enjoy from the Chinese government and the better legal regulatory framework established for this mode. Local partners in an EJV further mitigate the institutional uncertainty and business risk. CJVs are heavily clustered in the Pearl River Delta, the Chao-Shan Area, and Shanghai, with very few being located elsewhere in the country (Fig. 4). The less stringent legal

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Fig. 4. Distribution of urban contractual joint ventures (CJVs).

requirements for CJVs create enormous business uncertainties for foreign investors not familiar with the Chinese environment, but the flexibility, small scale, and opportunity for rapid return that characterize this mode are an inducement for ethnic Chinese abroad to return to mainland China via this mode (Fu, 2000). Indeed, the most desirable locations for overseas Chinese investments are indeed the Yangtze River Delta and Guangdong, since they are the “hometowns” of many overseas Chinese investors (Leung, 1990; He, 2003). Finally, WFOEs mostly are concentrated in the Pearl River Delta, the Chao-Shan Area, the Yangtze River Delta, Beijing, Tianjin, and coastal Fujian province (Fig. 5). Those locations are where most of the SEZs, OCCs, and ETDZs are located. WFOEs were initially permitted only in those policy zones in the 1980s. This entry mode, which involves greater operational hazards, greater financial costs, and more organizational commitment, concentrates in the policy zones in order to take advantage of the favorable institutions and investment incentives. Regression Results Table 2 presents Pearson correlation coefficients for the independent variables. Not surprisingly, a city’s opening time (TIME) is strongly related (r = 0.6158) to its previous stock of FDI (PFFE) and to the percentage of urban non-state employment (PRIV; r = 0.6394). In order to minimize multicollinarity, the variable TIME is excluded from the models. All other correlation coefficients are fairly low. The regression-based tests show significant evidence

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Fig. 5. Distribution of urban wholly foreign-owned enterprises (WFOEs).

Table 2. Correlation Coefficients among Independent Variables

PFFE INDU MART PORT TIME ZONE PRIV WAGE

PFFE

INDU

MART

PORT

TIME

ZONE

PRIV

WAGE

1.000

0.5708 1.000

0.1238 0.3084 1.000

0.4121 0.3526 0.1337 1.0000

0.6158 0.4239 0.2261 0.5293

0.4270 0.4827 -0.0105 0.3975

0.4663 0.1488 0.03650 0.3063

-0.1878 -0.2603 -0.1111 -0.1636

1.000

0.3979 1.000

0.6394 0.1218 1.0000

-0.2721 -0.1855 -0.1212 1.0000

of overdispersion in the CJV and WFOE models. A negative binomial regression model is thereby applied to estimate the parameters in the two models, whereas the Poisson regression model is used for JVs. Estimated coefficients and associated marginal effects are presented in Table 3. Results of the statistical analysis reveal both similarities and differences in the locational determinants of EJVs, CJVs, and WFOEs. The most substantial differences exist between

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Table 3. Results from Poisson and Negative Binomial Regressionsa EJVs Variables Constant

3.91470 (0.0000) 0.00128 (0.0000) 0.00015 (0.0000) 0.00004 (0.0000) 0.12407 (0.0000) 0.38453 (0.0000) 0.01998 (0.0004) -0.02524 (0.0000)

PFFE INDU MART PORT ZONE PRIV WAGE No. of observations Test for overdispersion LogL χ2 α aNumbers

β

282 0.128 (0.8983) -4558.369 30156.33

CJVs

Marginal effects

0.0856 0.0098 0.0024 8.2795 25.6612 1.3331 -1.6843

β -1.24571 (0.0001) 0.00288 (0.0051) 0.00017 (0.0115) 0.00001 (0.8543) 0.45052 (0.0479) 0.54327 (0.0262) 0.14105 (0.0000) -0.02027 (0.0000) 282 3.309 (0.0000) -598.39 1216.56 0.7843 (0.0000)

WFOEs

Marginal effects

0.0467 0.0028 0.0001 7.5511 9.1057 2.3642 -0.3399

β

Marginal effects

-0.53166 (0.0986) 0.00626 1.8089 (0.0000) 0.00028 0.0820 (0.0000) -0.00001 -0.0033 (0.6677) 0.27781 80.2275 (0.0100) 0.88900 256.7278 (0.0001) 0.10041 28.9954 (0.0000) -0.00819 -2.3651 (0.0043) 282 4.376 (0.0000) -795.58 5933.49 1.0295 (0.0000)

in parentheses are p values.

JVs (EJVs and CJVs in aggregate) and WFOEs. Both previous FDI stocks (PFFE) and the number of industrial enterprises (INDU) are fairly significant in the three model estimations, indicating the critical role of agglomeration economies in attracting new foreign enterprises. The marginal effects of PFFE and INDU show that WFOEs, to a greater extent than JVs, are more likely to be located in cities that host many foreign enterprises and have developed strong industrial bases. Sites of previous investments become key points for the accumulation of business information, which is partly transmitted through business relationships to other investors. The existence of foreign enterprises also may suggest that local governmental and economic agencies have amassed considreable experience in dealing with foreign investors, thereby substantially mitigating transaction costs. Cost-savings derived from locating in industrial clusters could significantly attenuate the risks and external uncertainties WFOEs investors encounter in host economies. The results above suggest that foreign investors who intend to establish EJVs value access to the domestic market highly, whereas those selecting CJVs or WFOEs are not as interested in good market accessibility, as indicated by the different significance of coefficients on the variable MART. As discussed previously, the EJV Implementation Act allows

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EJVs to sell domestically, whereas the WFOE Law requires export performance for the approval of new WFOEs. CJVs are used mostly for lower–value added export-processing operations. The statistical results also indicate that port cities are more attractive to foreign investors, particularly those selecting the WFOE mode of investment. The different responses of EJVs, CJVs and WFOEs to (domestic) market accessibility are consistent with their distinctive investment motivations and legal requirements. The empirical results illustrate that patterns of foreign investment in effect mirror China’s gradual and regionally oriented transition processes. More specifically, such investment is attracted to cities that were opened to the world earlier, were the objects of favorable state policy designed to attract foreign investment, and which have liberalized economic regimes. The marginal effects of ZONE and PRIV illustrate that WFOEs, as the most risky entry mode, are much more likely to concentrate in cities that have significantly benefited from the Open Door Policy and economic transition than are EJVs or CJVs. This can be characterized as a rational locational choice. First, WFOEs located in policy zones are provided with a greater number of institutional guarantees. Officials of these zones are authorized to prepare their own investment regulations, independently examine and approve investment proposals up to a certain level, issue licenses and land use permits, and coordinate the work of banking, taxation, customs, and frontier inspection personnel (Fu, 2000). Second, financial incentives in those zones substantially lower enterprise production costs, which, in turn, improve the competitiveness of WFOEs in international markets.6 Finally, the experiment of establishing a market-oriented economy in China was initially introduced in the SEZs, OCCs and ETDZs. WFOEs have tended to locate in these more liberalized economic environments to minimize business risks, since foreign investors here are able to follow market rules similar to those prevailing in their home countries. Unlike those in WFOEs, JV investors can share business risks and responsibilities with their local partners, who are rooted in the local investment environments. With the help of these local partners, JVs can position themselves more flexibly in the transitional economy. Despite these similarities, some differences can be identified between CJVs and EJVs. Compared to EJVs, CJVs are more likely to favor cities where non-state economies are critical components and less likely to be clustered in the policy zones, as suggested by the magnitude of the marginal effects of PRIV and ZONE. This reflects a couple of factors. First, a CJV is regulated by a less strict legal regime and does not have to achieve the status of a Chinese legal business entity. Locating in a liberalized investment environment may mitigate some of the institutional uncertainties CJVs encounter. Second, as Fu (2000) has reported, CJVs are especially popular among overseas Chinese investors and their daily managerial tasks are routinely run by relatives and personal friends and, as noted earlier, are often located in the (de facto or ancestral) hometowns of the Chinese diaspora.7 In addition, higher real labor costs are found to strongly discourage foreign investors, as shown by the significant negative coefficients of the variable of WAGE. Marginal effects of WAGE indicate that WFOEs are more sensitive than JVs (in aggregate) to real labor costs, whereas CJVs are the least likely to be influenced by real labor costs. WFOEs, confronted with enormous business uncertainty and risks, can further lower production costs and secure 6For example, a much greater number of favorable investment incentives are granted to foreign projects selling abroad or applying advanced technology in their production, which as noted above is a statutory requirement for WFOEs. 7In addition to such cities as Guangzhou, Shanghai, and Shenzhen, the most favorable locations for CJVs are the well-known hometowns of many overseas Chinese.

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their operations by locating in low-labor-cost locations. The CJVs’ moderate sensitivity to labor costs, shown by the marginal effect of WAGE, may be associated with their major characteristics: popularity among overseas Chinese investors, small scale, and flexibility in management and financing. DISCUSSION AND CONCLUSIONS Foreign investors may enter China via three principal entry modes: EJVs, CJVs, and WFOEs. Each is essentially different in terms of its legal form, risk characteristics, resource commitment, and investment motivations. EJVs are characterized by mature institutional support and the presence of local partners to share responsibility and risks. Many foreign investors choose EJVs to penetrate the Chinese market. CJVs face less stringent legal requirements; the parties involved cooperate in specified joint projects according to the conditions and terms stipulated in a contract, which can generate institutional uncertainties. Most CJVs are in lower-value-added export-processing operations. WFOEs may maintain full control over their operations and are more flexible and independent in managing production, financing, and marketing decisions. However, lacking the help of local partners, WFOEs have higher operational risk, greater financial costs, and a deeper organizational commitment, and also must satisfy more stringent performance requirements, either exporting 50 percent of their total output or applying advanced technology in their production. The WFOE mode is the most risky of the three in transitional China. The substantial differences among the three entry modes have distinctive locational implications. Understanding the locational patterns of EJVs, CJVS, and WFOEs may not only guide the locational decisions of potential investors, but also provide scientific support for local governments to in designing policies to attract appropriate modes of investment. The existing literature in general has not devoted sufficient attention to the influence of entry modes on FDI location. This paper has attempted to evaluate and compare the locational behaviors of EJVs, CJVs, and WFOEs in China based upon the most recent industrial census in 1995. Foreign investors in China in general favor the eastern coastal region. The three entry modes, however, exhibit different locational patterns. EJVs are more dispersed in space than the other investment modes, having diffused to the central part of the country and even to western China from the coast. CJVs are the most spatially concentrated mode, and are heavily clustered in the Pearl River Delta and the eastern Guangdong area in Guangdong province and Shanghai. WFOEs tend to concentrate mostly in the Pearl River Delta, the eastern Guangdong area, the Yangtze River Delta, Beijing, Tianjin, and the coastal Fujian province. The results of statistical analysis highlight some similarities and differences in the locational determinants of EJVc, CJVs, and WFOEs. Regardless of their entry modes, new foreign manufacturing enterprises by and large are attracted to existing industrial clusters and concentrations of already functioning foreign investment enterprises, indicating the critical role of agglomeration economies in attracting foreign investors. Foreign enterprises also tend to follow the temporal and spatial processes of economic transition, gravitating toward areas where reforms have been initiated and avoiding high-labor-cost locations. The most significant differences among the three modes are found between JVs and WFOEs. Compared to JVs, WFOEs are more likely to be located in cities that host many foreign enterprises and have developed strong industrial bases. As the most risky entry mode, WFOEs are also inclined to concentrate in areas benefitting from the Open Door Policy and economic transition, and to lower production costs by locating in low-labor-cost locations. The highest concentrations of EJVs are found in cities with greater market potential, whereas

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CJVs and WFOEs appear to be insensitive to that variable, which is consistent with their different investment motivations and legal requirements. The temporal evolution of economic liberalization has indeed driven the choice of foreign entry modes in China. As economic transition proceeds and institutional uncertainties recede, foreign entry modes have evolved from risk-averse joint ventures to more aggressive wholly foreign-owned enterprises. The spatially biased Open Door policy has also attracted the more risky entry modes to cities that possess policy, institutional, and locational advantages. The significant improvement in the FDI regulatory framework and liberalized economic environments will be the most critical factor affecting FDI inflow at the subnational level over the long term. The empirical findings of this study have important policy implications for foreign investors. For those seeking to explore the Chinese market for the first time, the less risky EJVs are the best entry mode because they afford the most flexibility in securing a profitable location. Moreover, EJVs allow foreign investors to benefit from the expertise of local partners and the institutional support of local governmental agencies. For those foreign investors viewing China as a platform for export activities, however, WFOEs would be the more appropriate mode, as they allow the foreign investor to maintain full control over operations and to obtain favorable tax treatment. The most desirable locations for WFOEs are the coastal cities. REFERENCES Beamish, P. and J. Banks, “Equity Joint Ventures and the Theory of the Multinational Enterprises,” Journal of International Business Studies, 18, 1:1-16, 1987. Broadman, H. and X. Sun, “The Distribution of Foreign Direct Investment in China,” The World Economy, 20, 2: 339-361, 1997. Cameron, A. and P. Trivedi, “Regression Based Tests for Overdispersion in the Poisson Model,” Journal of Econometrics, 46, 2:347-364, 1990. Chadee, D. and F. Qiu, “Foreign Ownership of Equity Joint Ventures in China: A Pooled-Cross-Time Series Analysis,” Journal of Business Research, 52, 2:123-133, 2001. Chen, C., “Regional Determinants of Foreign Direct Investment in Mainland China,” Journal of Economic Studies, 23, 1:18-30, 1996. Cheng, L. and Y. Kwan, “What Are the Determinants of the Location of Foreign Direct Investment? The Chinese Experience,” Journal of International Economics, 51, 1:379-400, 2000. Coughlin, C. and E. Segev, “Foreign Direct Investment in China: A Spatial Econometric Study,” The World Economy, 23, 1:1-23, 2000. Dunning, J., Multinational Enterprises and the Global Economy. London, UK: Addison Wesley, 1993. Dunning, J., “Location and the Multinational Enterprises: A Neglected Factor?,” Journal of International Business Studies, 29, 1:45-67, 1998. Fu, J., Institutions and Investments: Foreign Direct Investment in China during an Era of Reforms. Ann Arbor, MI: The University of Michigan Press, 2000. Gong, H., “Spatial Patterns of Foreign Investment in China’s Cities, 1980–1989,” Urban Geography, 16, 3:189-209, 1995. Greene, W. H., Econometric Analysis, fourth ed. Upper Saddle River, NJ: Prentice Hall, 2000. Guimaraes, P., O. Figueiredo, O. and D. Woodward, “Agglomeration and the Location of Foreign Direct Investment in Portugal,” Journal of Urban Economics, 47, 1:115-135, 2000. He, C., “Information Costs, Agglomeration Economies, and the Location of Foreign Direct Investment in China,” Regional Studies, 36, 9:1029-1036, 2002. He, C., “Location of Foreign Manufacturers in China: Agglomeration Economies and Country of Origin Effects,” Papers in Regional Science, 82, 2003, forthcoming.

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