Impact of Foreign Bank Presenceon Foreign Direct Investment in China.docx

40china & world economy / 4059, vol. 23, no. 4, 2015impact of foreign bank presence on foreign direct investment in chinasteven ongena, shusen qi, fengming qin*abstractwe analyze the impact of foreign bank presence on foreign direct investment (fdi) in china. the connection between the two could be particularly relevant for an emerging economy like china because the supply of financial services provided by banks may act as a constraining factor. foreign bank presence may then enable and foster fdi and not simply result from it. our estimates demonstrate that fdi across regions in china is increasing in the existing network of regional branches of foreign banks, which itself is driven (and, therefore, instrumented) by the timing of the regional phasing out of the local limits for foreign banks on local currency business. the effect of foreign bank presence on fdi is particularly strong for some specific sectors (farming, manufacturing, construction, transportation, wholesale/ retail trade and real estate) if those sectors are strongly represented in the source economies.key words: china, foreign bank presence, foreign direct investment jel codes: g21, f21i. introductionforeign direct investment (fdi) in the non-financial sector began to pour into china as early as 1992. since 1996 annual actual inflows have been over us$40bn, topping us$112bn in 2012 and making china the largest recipient of fdi in the world. 1 the inflows remained*steven ongena, professor, department of banking and finance, university of zurich, zurich, switzerland. email: steven.ongenabf.uzh.ch; shusen qi, phd candidate, department of finance, maastricht university, maastricht, the netherlands. email: ; fengming qin, professor, department of finance, school of economics, shandong university, jinan, china. email: .1even raising the specter that fdi to china may be crowding out fdi to other countries (resmini and siedschlag, 2013). fdi has played a particularly beneficial role in china in spurring innovation, export activity and economic growth (e.g. jeon et al., 2013), though it may also have temporarily contributed to regional inequalities (lessmann, 2013).2015 institute of world economics and politics, chinese academy of social sciencesimpact of foreign bank presence on fdi in china49remarkably resilient during the financial crisis. all in all china accounted for one-fifth of total developing-economy fdi inflows between 1992 and 2012. fdi has been the predominant means through which china has received global capital. a large proportion of the fdi has flown into the manufacturing industry and has come from other east asian economies, particularly hong kong and singapore.foreign banks have been present in china since 1979, with the opening of a representative office of the export-import bank of japan in beijing. from then on there was a gradual increase in foreign bank presence. china s entry into the world trade organization (wto) in 2001 quickened the process of the liberalization of access to foreign investors to many service sectors, including the financial sector. by the end of 2011, 181 foreign banks from 45 economies and regions had established a total of 387 local institutions (including headquarters, branches and subsidiaries), representing us$350bn in total assets and a market share of 2 percent, and with profits after tax equal to us$2.5bn.yet, despite the importance of both fdi and foreign bank presence for china, no study (that we know of) has investigated their correspondence. the connection between the two may be particularly relevant for an emerging economy like china because the supply of financial services provided by banks may act as a constraining factor; that is, fdi may be held back by the lack of technical financial expertise locally or by the absence of local soft information. foreign bank presence may then enable and foster fdi and not simply result from it.2we therefore study the impact on fdi of foreign bank presence in china. to identify its impact we hand-collect data on both fdi and foreign bank presence by region and by “source” country. we know that fdi across regions in china is influenced by government policy, which, in principle, focused first on the initially most developed cities or provinces, followed by a focus on the less-developed ones. at the same time, banks from various economies may assist investment by providing information and financial services to their home economy firms in specific sectors across regions according to their own sector expertise.the five essential ingredients in our identification strategy are, therefore: (i) the variation across regions in the timing and the magnitude in fdi, to be explained by (ii) the variation2a literature going back to goldberg and saunders (1981) asserts that banks often pursue a “follow-the- customer” strategy when deciding upon cross-border market entry. recent evidence, however, casts some doubt on the “follow-the-customer” strategy as the sole explanation for cross-border bank entry and presence (focarelli and pozzolo, 2005). banks entering the us market, for example, did not only have a lending-to-the-home-country-customer motive but were also engaged in providing other financial services to local and third-country clients (e.g. buch and golder, 2001). at the same time, home-country firms may seek “concierge” services from host-country banks (berger et al., 2003).across regions in china in the timing of entry and presence of foreign banks (as captured by the number of foreign banks regional branches), and instrumented in various specifications with (iii) the timing of the phasing out of the local limits for foreign banks on local currency business, and/or interacted with (iv) the variation in relative sector importance across regions and source economies, while accounting for (v) region economy, region time and/or regionsector fixed effects. all in all, we collect fdi and foreign bank branch data across 12 regions, 7 source economies and 6 sectors for the full period between 1996 and 2010.our estimates demonstrate that fdi across regions in china is increasing in the existing network of regional branches of foreign banks, which is also the case when foreign bank presence is instrumented with the timing of the regional phasing out of the local limits for foreign banks on local currency business. this effect of foreign bank presence on fdi is particularly strong for those sectors (farming, manufacturing, construction, transportation, wholesale/retail trade and real estate) that are importantly represented in the source economiesthese findings are also economically relevant. for example, estimates show that having one extra foreign branch in the region (the mean number equals 3.6) boosts yearly fdi by us$23m, or 4 percent compared to its mean (which equals us$524m). a one-unit increase in a measure of foreign bank presence in a nearby financial center (this measure also accounts for the distance to this financial center and its mean equals 1.31) boosts fdi by almost us$121m. in sum, foreign banks act as possible facilitators for fdi in china coming from their home economies.as such, our paper aims to make a contribution to various important strands of the literature that document and explain fdi with bank-specific variables, 3 the salient (and often beneficial) roles played by foreign banks, especially in developing economies, in fostering local credit markets and spurring real activity, 4 and recent developments in the banking sector in china.5 our paper also fits in a much larger literature that investigates the role played by financial development in alleviating credit constraints for households and firms, and in fostering economic growth in developing economies (levine, 2005) and in3see, for example, klein et al. (2002). we fully account for the many other factors that have been shown to contribute to regional fdi in china (e.g. sun et al., 2002) with region and region-time fixed effects that are included in the various specifications.4see mian (2006), detragiache et al. (2008), gormley (2010), giannetti and ongena (2012) and bruno and hauswald (2013), among others. for recent reviews see, for example, claessens and van horen (2014) and claessens and van horen (2013).5studies on foreign bank entry in china include bonin and huang (2002).china in particular (e.g. allen et al., 2005; chong et al., 2013).the rest of the paper is organized as follows. section ii describes fdi and foreign bank presence in china. section iii discusses the sample analyzed in the present study and defines the variables. section iv estimates the impact of foreign bank presence on fdi in china. section v concludes.ii. foreign direct investment and foreign bank presence in china1. foreign direct investmentchina is one of the most attractive investment destinations in the world and it receives, by far, the most fdi among the emerging economies. in 2012, the number of new foreign enterprises permitted to set up branches or subsidiaries in china equaled 24 925; the actual level of foreign capital was us$112bn. foreign investment in fixed assets increased by almost 11 percent; total exports and imports by foreign-invested enterprises (fie) increased by 1.9 percent and, in particular, exports of high-technology products increased by3.5 percent (ministry of commerce, 2013). in the same year, tax revenues from fie increased by 7 percent. what is clear from these statistics is that fdi stimulates the chinese economy and that it serves chinas economic growth and reform objectives, as well as those of the global direct investment community.foreign direct investment in china experienced two turning points, one in 1991 and one in 1999. beginning in 1991, when the liberalizing measures took effect, fdi flows began to grow at very high rates. by 1995, china had become the second largest recipient of fdi among all nations (the usa was in first place). around 1999, there was a second wave of fdi inflows due to the anticipation of china becoming a formal member of the wto in the near future. the stable currency and high economic growth in china after the 1997 asian financial crisis also strengthened the confidence of international investors. impressively, unlike the first wave during the early 1990s, this second wave took place during a time when total worldwide fdi was declining (unctad, 2002). indeed, in 2002 and 2003, china became the nation receiving the largest amounts of fdi, surpassing even the usa, which held this position from the late 1980s until 2001 (graham, 2005).the distribution of fdi is highly unbalanced among the regions in china. during 1979 to 1991, approximately 43 percent of all fdi in china was directed towards guangdong and fujian provinces, where the special economic zones (sez) were located. the government established four sez in these two south-eastern coastal provinces. these sez were chosen with a clear intention of attracting investment from “overseas chinese.” foreign investors in sez were given some favorable treatment. as time went by, more regions were opened toinvestment from the outside world. the sez “example effect” extended to other coastal cities and provinces, the so-called “sez-like” areas. an additional 27 percent of the total fdi went to the coastal provinces containing economic and technology development zones (etdz). thus, 70 percent of total fdi in china during this period went to the regions with sez or etdz. however, since 2001, due to the government policy preferences for the less developed regions in china, the fdi growth rates in central and western china are higher than the national average, gradually mitigating the regional unbalanced distribution of fdi inflows.foreign direct investment also varies widely by source economies. most of the early fdi in sez and coastal regions came from the so-called “overseas chinese” located in hong kong, taiwan and the rest of east asia (e.g. singapore). 6 fdi from other parts of the world, especially western europe and north america, increased steadily throughout the 1990s. at the very beginning of the 1980s, investors came from less than 30 economies or areas in the world; now the number has increased to more than 170. however, fdi across source economies is still very unbalanced. in 2012, the total fdi from hong kong amounted to us$71bn, accounting for 64 percent of china s fdi inflows. japan, singapore, taiwan and the usa followed with us$7.38, 6.54, 6.18 and 3.17bn, respectively. the top six source economies together make up 87 percent of total fdi volume. investment from the european union was us$6.11bn in 2012, topped by germany, the netherlands, the uk and switzerland (ministry of commerce, 2013).2. foreign bank presenceforeign banks have been present in china since 1979, with the opening of a representative office of the export-import bank of japan in beijing. from then on there was a gradual opening to foreign bank presence. china s entry into the wto in 2001 quickened the process of the liberalization of access to foreign investors to many service sectors, including the financial sector. by the end of 2011, 181 foreign banks from 45 economies and regions had established a total of 387 local institutions (including headquarters, branches and subsidiaries), representing us$350bn in total assets and a market share of 2 percent, and with profits after tax equal to us$2.5bn.there are several key points to note about this process. before 1992, foreign exchange business was only allowed within the sez. however, in 1992 these regional restrictions were relaxed, with foreign exchange business allowed in a further 7 coastal cities. this6zhang (2005), for example, argues that fdi coming from hong kong and taiwan was mainly driven by low labor costs. we account for regional differences in labor costs with region and region-time fixed effects.number increased to 24 in 1995. between 1996 and 1998, shanghai and shenzhen became the first cities that allowed foreign banks to conduct renminbi (rmb) business. the people s bank of china (chinas central bank) announced in 2000 that it would phase out the geographical limits of rmb business to foreign banks. according to the wto commitment in 2001, at the end of 2006, there would be no restrictions for both regional locations and business lines to foreign banks. national treatment was given to all foreign financial institutions, which provides a level playing field to both domestic and foreign financial institutions.since it became the member of wto at the end of 2001, china has gradually removed restrictions on foreign bank presence. as a result, the number of foreign bank branches, the size of assets and deposits, and the extent of foreign ownership of domestic institutions have been growing rapidly. according to the governor of the cbrc, foreign banks and other financial institutions have become an important power in china s financial system. however, the market share of foreign banks is still small relative to the national banking institutions and commercial banks in china. foreign banks only contribute 0.67 percent to the total profits of chinas banking industry. the number is less than 2 percent when it comes to the total assets.the expansion of foreign banks is, however, limited by the laws and regulations of the supervisory and regulatory institutions of china. according to the cbrc, for foreign banks to develop in china, the following principle must be adhered to (yang, 2008, p.7):starting with the national conditions of china, grasp the opportunities, forces and rhythm for opening to the outside world, adhere to gradual and orderly opening to the outside world in line with macro-level policy and market development, and make the opening to the outside world gradually expand from the coastal and developed regions to regions in central and western china.as a result, almost all foreign bank branches are located in the coastal cities in eastern china, and, in particular, are concentrated in well-developed cities such as shanghai, shenzhen, guangzhou, beijing, tianjin, dalian and xiamen.the highly unbalanced nature of foreign bank presence in china by source economy mainly depends on two factors: the history of trading relationships and the different global strategies of various multinational banks. of course, china s recent accession to the wto also attracts foreign banks from other economies in the world (i.e. economies other than foreign trading partners). by the end of 2006, the top 6 source economies (or regions) were hong kong (99), the usa (26), the uk (21), japan (19), singapore (17) and france (15). intotal they made up two-thirds of the total foreign bank institutions in china ( cbrc annual report, 2006).iii. sample, methodology and variables1. samplefor the present study we have collected fdi and foreign bank branch data across 12 regions (beijing, shanghai, guangdong, liaoning, tianjin, fujian, shandong, shanxi, jiangsu, hubei, chongqing and zhejiang), 7 source economies (france, germany, hong kong, japan, singapore, uk and usa) and 6 sectors (farming, manufacturing, construction, transportation, wholesale/retail trade and real estate) for the full period between 1996 and 2010. we chose this time period because between 1996 and 1998, shanghai and shenzhen became the first cities that allowed foreign banks to conduct rmb business and the peoples bank of china announced in 2000 that it would phase out the geographical limits of rmb business to foreign banks. this phasing out of limits will be used in our analysis as an instrument for foreign bank presence in china.with respect to the selection of