A causality analysis of the FDI‐wages‐productivity nexus in China

The purpose of this paper is to examine the relationships between foreign direct investment (FDI), wages and productivity in China. The direction of causality among these variables is also to be emphasized.

The authors develop a system of equations and test the relationships based on a vector autoregressive regression (VAR) model and two‐step generalized method of moments (GMM)‐type estimation approach. They use a panel data set of China's provinces for a 20‐year time period, 1988‐2007, and also distinguish between the coastal and inland provinces.

The result confirms the cheap labor argument for China, although this particularly true for inland provinces. In the coastal provinces, FDI inflow influences the wage rates upwards. FDI also has a positive effect on productivity, particularly in the coastal provinces, but does not act as a significant determinant of FDI.

Factors other than wage rates and labor productivity are also important determinants of FDI. This paper focuses on the interplay of these three variables, while assuming other factors constant.

Cheap labor as an attraction of FDI is a short term policy. Improvements in productivity should be the focus both in the coastal and the inland provinces. A conducive business environment, a suitable education policy and incentives for greater R&D contribute toward improving labor productivity, which in turn attracts greater FDI inflow.

The paper provides empirical evidence on the direction of causality between FDI inflow, wages rates and labor productivity in one system of equations.