Wei Zhang is currently a D.Phil. Student in economics at St Anthony’s College, University of Oxford. He will be lecturer in Chinese economics and management at University of Cambridge from October. He got BA and MA from Peking University, MPA from Kennedy School of Government at Harvard. He worked in Tianjin Municipality in charge of foreign investment and international trade in during the period from 1982 to 1989. The author wishes to thank Ms. Nancy Hearst of Harvard University’s Fairbank Center. Ms. Hearst graciously provided various data and patiently edited the original manuscript.

It has been widely recognized that the surge in foreign trade and investment in the coastal areas of China is an important factor that contributes to unbalanced economic growth among China’s various regions. The obvious question then becomes: "Why is it that such foreign investment is not evenly spread across areas or provinces, and is instead concentrated in the coastal regions?" The concentration of foreign investment in the coastal areas is often attributed to the central government’s discriminatory regional policies, particularly its preferential treatment of the external sector.¹ This article argues that the policy preferences concerning the coastal areas by the central government do not constitute the fundamental reason for the unbalanced foreign investment in China. Rather, there are other, more comprehensive explanations regarding the unbalanced distribution of foreign investment across China, each of which have distinct policy implications for the prospect of tackling regional disparities.

I. The Comparative Advantages of the Coastal Areas in Attracting Foreign Investment

The theory of location explains the incentives of multinationals to invest in foreign countries. It claims that the location of production is determined by both economic resources and policies of the host countries. Moreover, the main considerations within multinational investment decisions are the comparative advantages of the host areas in terms of production factors and of proximity or accessibility to the market. Compared with the central and western areas, China’s coastal region possesses several comparative advantages that had been repressed by the autarkic Maoist policies prior to the opening of the door to the outside world.

The general efficiency of the labor force is higher in the coastal areas than it is in the central and western areas. Table 2-1 and Table 2-2 show that labor productivity in the coastal areas was 25, 23, 20, and 40 per cent higher than the average national labor productivity in 1980, 1985, 1990, and 1995, respectively. These tables also show that labor productivities in the coastal areas in three industries were consistently higher than that of the central and western regions during all the periods. The three industries refer Primary Industry (agricultural and mineral), Secondary Industry (manufacturing), and Tertiary Industry (service sector), Higher productivity strongly correlates with a higher educational level. The number of college students per thousand in the coastal areas was 33, 29, 35, and 38 per cent higher than those in the central areas in 1980, 1985, 1990, and 1995, respectively. The number of coastal college students in comparison with the western areas was also 52, 45, 47, and 55 per cent higher for the same years. Accordingly, coastal areas attract foreign investment because higher education has made labor more efficient and productive.

When comparing the average annual wage of urban workers in the three regions, one finds that before 1990, the wage rate in the coastal areas was actually lower than that of the central and western areas. (See Table 1.) The average wage rate of urban workers in the western areas was 13 per cent higher than that of their counterparts in the coastal areas in 1980, and 12 per cent higher in 1985. In contrast, there was no significant difference between the average wage rates in the coastal and central areas. This situation has gradually changed during the reform era. While the wage rate of the western areas declined in relative terms, the coastal areas wage rate grew. By 1990 however, the average wage rate in the central areas was significantly lower.

Infrastructure is essential for foreign investors to conduct business successfully. Infrastructure facilities, including transportation, communication, electricity, and water supply are more advanced in the coastal areas than in the central and western areas. Table 3 shows that the length of railway per thousand squared kilometers in the coastal areas was 120 and 493 percent of that in the central and western areas respectively in 1978, 144 and 576 percent in 1985, and 148 and 645 percent in 1990. The length of highway per thousand squared kilometers in the coastal areas was 164 and 448 per cent of that in the central and western areas respectively in 1978, 178 and 416 per cent in 1985, and 184 and 429 per cent in 1990.

In addition, many foreign-invested industries need upstream and/or downstream industries to provide components or to absorb their products. Therefore, the comparatively more developed industries in the coastal areas have an advantage to attracting foreign investment. There exist no data about industrial structures across provinces. Nevertheless, the value added of secondary industries in the three areas demonstrates a contrast in terms of industrial capacities. The value added of secondary industries in the coastal areas was 99, 100, 110, and 134 per cent higher than that in the central areas in 1980, 1985, 1990, and 1995, respectively, and 108, 102, 99, and 109 per cent higher than that in the western areas for the same years, indicating higher industrial capacity in the coastal areas.

The Chinese government requires that almost all foreign-invested firms produce for export, making access to seaports for foreign investment essential. Ninety percent of China’s international trade must pass through its seaports. The government’s main purpose of introducing foreign investment is to absorb advanced technology and management skills and to mitigate the pressures from its large and redundant labor force. Like most developing countries, China has been very reluctant to allow foreign investors access to its domestic markets. Since it first permitted foreign direct investment in 1979, the government has enacted a series of state laws and regulations that confirm the export requirements for foreign-invested firms. Since 1986, the State Council has provided favorable tax treatments to those foreign-invested firms that introduce high technology and export their products. In 1995, a guide for foreign investment issued by the Chinese government encouraged only foreign investment that abided by the above requirements. Furthermore, all foreign-invested firms are required to balance their foreign currency accounts with their own export income. On the other hand, the import of input materials is indispensable for most export producers because China lacks sufficient mineral and agricultural materials.

Due to the above two requirements, the coastal area is naturally a better production location than the central and western areas. The fact that domestic transportation is both costly and unreliable further reduces the comparative costs of the coastal areas. Since construction of new expressways began only in the 1990s, the bulk of land transportation still relies on the antiquated railway system that is owned by inefficient state companies. The uncertainties of the train schedules, the high damage rates, and the exorbitant charges are more than enough to discourage potential customers from choosing production sites other than the coast.²

In addition, the coastal areas house the ancestral birthplaces of most overseas Chinese, and such familial and social networks serve to lower operational costs. Investment by overseas Chinese not only accounts for the lion’s share of total foreign investment in China (see Table 4), but also has a herd effect in inducing other investors to follow.

According to transaction theory, social-cultural distance is another important factor that affects foreign investment. Social-cultural differences between a potential host country and a potential investor’s home country create enormous information needs, thus raising information costs. Operating in an unfamiliar location also increases business uncertainty and unpredictability.

After investment by overseas Chinese grew increasingly established in the coastal areas, the herd effect led many other investors to follow. The herd effect is actually quite rational, and it can be justified by information externalities of two dimensions. One is an information externality to potential foreign investors, whereby successful pioneering investment reduces uncertainties and encourages others to follow suit. In the case of China, the information externalities also extend to administrative institutions and enterprises in the coastal areas that supervise foreign investment, or to those who are partners of potential joint ventures. These officials’ and potential partners’ past experience with overseas Chinese investors renders them familiar with international conventions and more comfortable with international investors. Thus for foreign investors, following the herd lowers operational costs and greatly reduces uncertainties.

There is no doubt that the policy of opening up to the outside world has greatly promoted economic growth since 1978. The move to embrace foreign investment has been an indispensable part of this policy. As in other aspects of reform, the Chinese government has implemented the opening-up policy gradually. It first opened the two provinces of Guangdong and Fujian, then the fourteen coastal cities, and afterwards other areas.

The coincidence of the spatial distribution of foreign investment and the regional bias of the central government policies has been advanced as the strongest support for the policy preference argument. In 1979, the central government granted the two provinces of Guangdong and Fujian certain autonomies to attract foreign investment and to open four special economic zones. Since then, these two provinces have taken the lead in absorbing foreign investment and have enjoyed the highest GDP growth. In 1984, most of these preferential policies were extended to fourteen coastal cities and their affiliated economic development zones, contributing to the faster growth of the coastal areas.

Nevertheless, there are also some counterexamples to this argument. In 1991, the central government further expanded the preferential policies to Heilongjiang, Jilin, Hubei, Hunan, Anhui, Shaanxi, and Sichuan, and in 1992 to Henan, Gansu, Yunnan, Guizhou, Jiangxi, Shanxi, Xinjiang, and Inner Mongolia. The economic development zones, high-tech industry parks, and special border economic zones approved by the central government in these central and western provinces accounted for 42 per cent of the total preferential policy areas nationwide. However, the share of foreign investment in these provinces did not thereafter experience significant increases. (See Table 5.)

Another counterexample is the case of Shanghai. Pudong Economic Development Zone was approved in April 1990, and it subsequently enjoyed the same preferential treatments as Guangdong and Fujian, but Shanghai’s share of foreign investment, as a percentage of the national total, did not increase thereafter. (Also see Table 5.) Six years prior to and six years following the establishment of the Pudong Economic Development Zone, Shanghai’s average share of foreign investment in the national total was 10.41 per cent and 7.8 per cent respectively.⁴ If we take into account the speculative investment in real estate in Shanghai in 1992 and 1993, which was higher than the average national level, the effective share of foreign investment was even lower than 7.8 per cent.

These examples contradict the generally accepted view on coastal versus regional income disparities. They demonstrate that the central government’s discriminatory regional policy with regard to foreign investment is not a fundamental reason for the unbalanced spatial distribution of foreign investment, nor is it a fundamental cause for the unbalanced regional growth. However, the central government’s policy does play a role in promoting foreign investment in the coastal areas. Most importantly, it loosens repressive constraints, allowing the inherent comparative advantages in the coastal area to be realized.

As to why the central government opened China’s door gradually, the answer involves political negotiation rather than economic reasoning. The opening was primarily the result of a compromise between the reformers and the conservatives within the party. In the mid-1980s, with the fading effects of the agricultural reform and the strong resistance from conservatives to further domestic reform, particularly reform of the state sector, reformers resorted to accelerated growth in the external sector to maintain national economic growth. Because of conservative opposition, a partial opening rather than a nationwide opening was preferred.⁵ Consequently fourteen coastal cities opened in 1984 and the coastal development strategy of Zhao Ziyang followed in 1987.

Changes in the preferential policies of the central government on foreign investment are usually understood as signals of change in the direction of economic policy as well as changes in the direction of regional policy. The opening of more areas is seen as a continuation and development of the "open-door policy." It is argued that thereafter more foreign investment will flow, not only to the newly opened areas but also to the rest of the country. In contrast, a revocation of some of the preferential treatments in specific areas is regarded as a step backward from the status quo, which will retard foreign investment not only in those specific areas but nationwide as well.

The concentration of foreign investment in the coastal areas is mainly due to the inherent comparative advantages that the coast holds for attracting profit-oriented investors. These advantages were obscured by repressive policies before China opened itself to the outside world. The "open-door policy" implemented since 1978 has lifted these repressive constraints and allowed investors to realize a host of advantages. On the other hand, the policy preference toward coastal areas in the 1980s was the product of a political compromise and did not play a fundamental role in affecting the inherently unbalanced distribution of foreign investment.

As a product of the comparative advantages of the coastal regions, this unbalanced distribution stems from a regional disparity that cannot be ameliorated simply by changes in regional policy. Rather, the achievement of regional equity is a long-term endeavor, requiring broader and more comprehensive institutional changes. Such an initiative demands not only improvements in infrastructure but also the introduction of policy changes on a nationwide scale. The government must seek to move beyond the mere tightening of preferential policies to the coastal areas, a strategy that has not proven to be effective. Rather, by further opening its domestic market and improving its legal system, China can reduce the element of uncertainty regarded as paramount to investment by foreign financial actors. Such a shift will serve to encourage investment further inland, thereby aiding China’s ostensible goal of national development.