Does FDI Harm the Host Country’s Environment? Evidence from Coastal and Interior China Helen Feng Liang University of California, Berkeley April 12, 2006

2 Why study trade and pollution? Environmental issues are global  global warming, ozone depletion, acid rain, etc. Trade could have impact on environment  WTO, NAFTA  Are dirty industries moving to the South? Trade could lead to growth, growth could be good or bad for the environment Trade policy and environmental policy

3 What makes China an interesting unit of analysis? Received a large amount of FDI in recent years A popular destination of manufacturing outsourcing Vast number of cities, large variety in location, economic development, access to foreign investment, and policy Increasing pollution problems

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6 Research Question? What’s the impact of foreign direct investment on the environmental quality in China? What are the channels of the impact?

7 Outline Introduction Theory Foreign Direct Investment and Environment in China Data, Measurement, and Empirical Strategy Result and Conclusion Discussion

8 How Does Trade Influence Pollution? Openness  Growth  Less or More Pollution Trade  More output  More pollution: Scale Effect Trade  Higher income  Higher demand for environ: Income Effect  Environmental Kutznet Curve: an inverse-U shaped relation between per capita GDP and Pollution level  Grossman & Krueger 1993, 1995, Frankel & Romer 1999 Openness  Tech Efficiency  Less pollution: Technique Effect Antweiler et al 2001, Frankel & Rose 2002 Wang & Jin 2002 Limitation of Cross Country studies: Endogeneity of Trade Policy and Environmental Policy Contribution of my study: within-country study to overcome endogenous trade policy

9 Foreign Direct Investment in China: What’s driving the distribution of FDI?  Government policy 4 special economics zones and 14 coastal open cities  Geographic location Closeness to sea ports/trade hubs: Shanghai, Hong Kong, etc FDI’s Effect on the Environment:  FDI  more pollution: more output  more pollution  FDI  less pollution: FDI  Tech Spillover  Improve Energy Efficiency FDI  Competition  Crowd out less efficient firms  Improve Overall Energy Efficiency FDI  Higher Income  Higher Demand for Environment  Ambiguous: FDI could go to dirty or clean industries

10 Hypothesis Hypothesis 1  EKC – Pollution level in China’s cities increases with per capita GDP, but at a decreasing speed. Hypothesis 2  Pollution level in China’s cities decreases with foreign direct investment, for given industrial composition and the level of output.

11 Environmental issues in China: SO2 is a major source of pollution due to the structure of fuel consumption ,000 1,200 1,400 1, Primary Consumption (Mtce) Primary Electricity Natural Gas Petroleum Coal Source: China Energy Databook V6.0 Figure 4.A.1

12 Environmental issues in China: China's Sulfur Dioxide Emission by Industry Sectors Source: China Statistic Yearbook 2003

13 Data Source panel of 231 cities in China: city-year observations  City level pollution Estimated industrial SO2 emission: China Urban Statistics Yearbook SO2 ambient concentration: China Energy Databook v6.0  Industry composition and ownership China National Bureau of Statistics  Other city social and economic variables China Urban Statistics Yearbook  Pollution intensity by industry sectors World Bank Industrial Pollution Projection System (IPPS)

14 Variables Dependent Variables – Sulfur Dioxide Emission:  Factory SO2 emission (tons) Explanatory Variables:  FDI sector: asset and employment of foreign invested plants  Domestic sector: asset and employment of domestic plants  Income: per capita GDP and per capita GDP square Control Variables:  Industrial output  Estimated SO2 emission based on industry composition Employment * SO2 emission per employee  Land area, capital labor ratio  Year effects, provincial dummies, city fixed effects

15 FDI v.s. Domestic Factories: Capital labor ratio  FDI are more capital intensive

16 FDI v.s. Domestic Factories: Expected SO2 emission per employee based on industry composition  FDI probably goes to “cleaner” industries

17 Empirical Strategy – A reduced form regression with IV SO 2 it = β 0 + β 1 * FDI it + β 2 *Domestic asset it + β 3 *income it + γ*X it + α i + Year t + ε it Where, FDI it = ρ 0 + ρ 1 * coastal i + ρ 2 * distance to sea ports i + µ it  All the terms are in logs

18 Empirical Strategy – Geography and Trade policy as instruments for FDI Challenge:  Unobserved variables influencing openness and income at the same time, and influencing pollution via income Solution: Geography and central government policy influence FDI at city level, but not the other way around  Similar technique used in Wei (2001) cross-city and Frankel and Rose (2002) cross-country studies Instruments:  Coastal Open Policy dummies: coded 1 if the city is one of the 18 open cities and special economic zones designated in the 1980s  Distance to Sea Ports and hubs of incoming FDI, Shanghai, HongKong, Dalian, QinHuangDao, and Taiwan

19 Cross-sectional Analysis Dependent Variable: LogSO2 in tons *** p<0.001, ** p<0.01, * p<0.05 All regressions include a constant, city level control variables, and year and provincial dummies.

20 Fixed Effects Dependent Variable: LogSO2 in tons *** p<0.001, ** p<0.01, * p<0.05 All regressions include a constant, city level control variables, and year and city fixed effects.

21 Conclusion and Caveats Conclusion  FDI  shows a negative effect on SO 2 factory emission  GDP  Supports Kutznet Curve, with all the cities on the left side of the hump Caveats  Other Pollutants: water, soil, etc 

22 Future Research Look for technology spillover effects  Within industry sectors  Between upstream-downstream sectors Look for crowd-out effects  Within industry sectors  Export vs domestic market  Labor supply and wage increase