Horizontal and vertical spillover effects of foreign direct investment in Chinese manufacturing

The purpose of this paper is to examine foreign direct investment (FDI) spillovers accruing to Chinese local industry at both intra‐ and inter‐industry levels and how such effects vary with the nationality of the investor.

A panel dataset for Chinese industry over the period 2000‐2002 is employed for an augmented production function with external factors being defined as the influences of externalities in production.

The paper provides evidence of positive spillovers working both within industries and between industries, and evidence of vertical effects being more important than horizontal effects. The results also show that Western multinational enterprises (MNEs) generate more vertical spillovers than their overseas Chinese counterparts. This latter finding confirms that it is necessary to break down inward FDI by foreign ownership, as this makes a significant improvement over previous findings.

Owing to data constraints, the design of the empirical framework does not allow a tightly defined source of potential vertical spillovers, i.e. a distinction of vertical spillovers through backward or forward linkages.

Given the strong evidence of vertical spillovers, the role of foreign MNEs in bringing local suppliers up‐to‐date with best practices should be counted amongst the policy benefits when judging whether it is appropriate to provide policy incentives to FDI. Policy effectiveness could be maximized at targeting specific types of foreign investor.

The paper assesses the relative importance of horizontal and vertical spillovers in a unified framework and the role of nationality of the investor.