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Foreign Direct Investment and Skill

Formation in China
a a
Bharati Basu & Jianfeng Yao
a
Department of Economics , Central Michigan University , Mount
Pleasant, MI, 48859, USA
Published online: 23 Jun 2009.

To cite this article: Bharati Basu & Jianfeng Yao (2009) Foreign Direct Investment
and Skill Formation in China, International Economic Journal, 23:2, 163-179, DOI:
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 International Economic Journal
Vol. 23, No. 2, 163–179, June 2009

Foreign Direct Investment and Skill

Formation in China
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BHARATI BASU & JIANFENG YAO

Department of Economics, Central Michigan University, Mount Pleasant, MI 48859, USA

(Received 4 September 2007; final version received 18 September 2008)

ABSTRACT Using panel data analyses, this paper examines the relation between human
capital formation and Foreign Direct Investment (FDI) in China. It shows that FDI has a
significant effect on human capital formation, at least for the period 1995–2001. When we
estimate the relationship between FDI and skill formation for the coastal and non-coastal
provinces separately, the positive relationship is maintained, and this relationship also holds
when we consider investment in real estate or the ratio of number of foreign firms to total
number of firms investing in China. The results stand robust in the causality test and the
sensitivity analysis.

KEY WORDS: China, FDI and skill formation

JEL CLASSIFICATIONS: F3, F35

Introduction
The development strategy by the People’s Republic of China after 1950 and espe-
cially during the last two decades has been the subject of intense scrutiny among
researchers, policy makers and media all over the world. Has China placed too
much emphasis on industry by ignoring agriculture? To promote growth, is China
facing ever increasing regional disparity? How is China performing in the move
towards globalization? Being a dominant participant in the global outsourcing,
has China engaged in human capital formation? These are some of the questions
researchers have tried to examine during the last decade.1

Correspondence Address: Bharati Basu, Department of Economics, Central Michigan University,

Mount Pleasant, MI 48859, USA. Email: b.basu@cmich.edu
1 See Chen & Feng (2000), Demurger et al. (2002), Jian et al. (1996), Tang (2002) for discussions of
different topics about China over the last several years.
1016-8737 Print/1743-517X Online/09/020163–17 © 2009 Korea International Economic Association
DOI: 10.1080/10168730902901106
 164 B. Basu & J. Yao

The literature on divergent rates of growth across countries cites the differences
in the level of the technological progress among countries as the reason for the
dispersion of the rate of growth.2 This technological progress sometimes becomes
endogenous and may be embodied in some factors of production such as labor
and/or capital. This type of technological progress transforms ordinary labor into
skilled labor known as human capital (that includes the ability to create a new
design, a new formula, or a new machine, etc). Thus, the existing level of human
capital as well as the growth of human capital plays crucial roles in promoting
growth.
However, countries with a low level of income can develop this human capi-
tal either through international trade/aid or by spending resources on research
and development, schooling, etc. One notable consequence of China’s open area
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policy is the flow of Foreign Direct Investment (FDI). Foreign investments have
increased and financial capital has been accumulating since China has started pay-
ing more attention in improving its capital market. The question is: has there been
an accumulation of human capital side by side with the improvement in financial
capital market or does FDI have any impact on human capital accumulation in
China?
In trying to examine the relation between FDI and skill formation in China’s
reformed economy, this paper finds that:

(1) foreign direct investments have a significant effect on human capital forma-
tion, at least for the period 1995–2001;
(2) considering the regional disparity in growth, when the relationship between
FDI and skill formation is estimated for the coastal and the non-coastal
provinces separately, the positive relationship is still maintained for both the
coastal and the non-coastal provinces for the period 1995–2001; and
(3) when we consider FDI in real state only, this positive relationship is
maintained.3

Discussion
The literature on human capital has long ago emphasized the importance of
human capital accumulation as a crucial ingredient for the growth of an economy.
This human capital accumulation may take the form of schooling, new skill for-
mation, more investment on research and development, on-the-job training and
innovation and invention. During the last two decades this crucial role of human
capital in promoting growth was reemphasized in the literature of endogenous
growth.

2 See Romer (1989, 1990), Barro (1991), Mankiw et al. (1992), Grossman & Helpman (1994).
3 The sectoral distribution of FDI in China is skewed. The notable feature of this sectoral distribution
is that a significant amount of FDI has gone to real estate. In spite of government policy aimed at
reducing new fixed investment, and in spite of a downturn of FDI in the hotel business, the FDI flow
in real estate has more than doubled between the 1980s and 1990s. Considering its importance in
attracting FDI flow, any analysis of FDI should focus on foreign investment in real estate separately.
 FDI and Skill Formation in China 165

Barro (1997) finds that differences in the per capita income among countries
are reduced if factors such as human capital formation or education level and
openness of economy are controlled. Barro (1991) used elementary school enroll-
ment as a proxy for initial stock of human capital. Romer (1989) also finds human
capital in the form of research leading to new technologies or innovating tech-
nologies as a significant factor for economic growth. It is argued that countries
with higher initial stock of human capital are more likely to have new products
and grow faster than other countries.
When FDI comes via MNE (Multi-National Enterprises), it increases demand
for skilled workers. Thus, the wages of the skilled workers go up and it creates
incentives for workers to acquire more human capital or become more skilled
(Slaughter, 2002). The foreign affiliates themselves spend more money on research
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and development (R&D) and this creates a competitive environment that encour-
ages domestic firms to engage in R&D. Slaughter shows that host affiliates to
US-owned companies increased their R&D expenses by 5% from 1982 to 1994.
This R&D facilitates or expedites technology transfer. The progress in technology
raises returns to skill or education and that induces an increase in the supply of
educated workers (Galor & Moav, 1998). Borenzstein et al. (1998) conclude that
‘FDI is a vehicle for the adoption of new technology, and therefore, the training
required to prepare the labor force to work with new technologies suggest that
there may also be an effect of FDI on human capital formation.’
Furthermore, spillover in host affiliates improves productivity and demand for
skilled workers of the domestic firms. The spillover can happen from reverse
engineering, or from labor turnover or from the supplies of intermediate goods to
MNE (Blomstrom & Persson, 1993; Kokko, 1994). Another way FDI stimulates
human capital formation is via capital deepening activities of host affiliates and
MNE, which increases demand for skilled workers further. FDI also creates an
environment of ‘Corporate Social Responsibility,’ which increases awareness of
and spending on general education.
Companies such as Shell, BP-Amoco, Exxon-Mobil spend millions on voca-
tional training, and formal education in the host countries. Furthermore, when
MNE provide a new stream of income, consumption expenditure goes up. The
governments come up with helpful fiscal policies so that educational expenses go
up too. Using 30 years of panel data for various countries, Dexter Gittens (2006)
shows that FDI increased growth of human capital in Asia and Latin America.
The host countries in their effort to lure more FDI invest in developing a skilled
and experienced labor force.
Following the reforms in 1978, China has shown efforts not only to open its
market to the outside world, but it also has become an active participant in the
global move towards economic integration of the world economy. During the last
two decades, China, along with many other developing countries, has exported
not only agricultural goods but also software services, computer parts, and other
intermediate goods. It suggests that to compete in the global market, China is
taking advantage of the revolution in information systems by making its workforce
more skilled than before. The rapid and large flow of foreign capital was visible
everywhere. In addition, China created Special Economic Zones, which led to
skills development of the coastal regions. The disparity in economic progress and
 166 B. Basu & J. Yao

thus in the living standard between its coastal and non-coastal provinces forced
China to move from its strict internal migration policy. This has led to changes
in its labor market.
During the last decade, quite a few studies have examined the inflow of FDI
into China and how it has affected the rate of growth of China’s economy and its
regional income inequality. Some of these studies (Broadman & Sun, 1997; Chen
& Fleisher, 1996; Chen et al., 1995) have suggested that in order to reduce the
regional dispersion of growth and to foster more growth nationally, China should
invest more on education and R&D along with investment on infrastructure, and
reduce barriers to free inter-provincial movement of labor and capital.
In examining the determinants of FDI, some of these studies (Cheng & Kwan,
2000; Chow, 1993; Head & Ries, 1996) imply that FDI in the form of multinational
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companies, or joint ventured companies may have been attracted to some of

China’s provinces because of the availability of skilled workers. At the same time,
foreign enterprises may have encouraged local workers to become skilled. Some
of the joint ventured companies may have created a new climate of research and
development. This argument is very much in line with the literature (Basu, 2006;
Jones & Marjit, 1995) on off-shoring or enclave-led growth. It says that when
foreign producers move into a province with their capital and skilled workers, it
is possible to affect the skill composition of the local labor market.
Since FDI in its various forms has now been accepted as an important engine of
growth in China’s reformed economy, it is interesting to see whether it has affected
the skill composition of China’s labor market. This paper provides an exploratory
data analysis to have an idea about how human capital formation in the form of
school enrollment has performed during the last few years when China attracted
a large amount of FDI into its economy.

Data, Data Analysis and Results

We mostly have relied on Chinese Year Book data, which have been used by a
large number of researchers. Furthermore, Chow (1993) has shown that Chinese
Year Book Statistics, by and large, are internally consistent and accurate enough
for empirical works.
In Table 1 we present information on per capita income (in current price) and
FDI in Yuan from 1978–2004. There is no information on FDI before 1978, which
is consistent with the fact that the years preceding market reforms are called the
years of protection and era of isolation.
The per capita income has increased from 615 Yuan to 16,024 Yuan between
1978–2004 and FDI has increased from 7.47 billion Yuan to 501.59 billion Yuan
nationally. In Table 2 we present the information available for Education. The
level of enrollment at college level and beyond college level increased. Note that
the growth in the Master and Doctoral levels was remarkably high.
In our effort to investigate the relation between FDI and the enrollment size,
we have used data for all the provinces in China from 1995–2001. This is due
to the fact, that no data were available for the period before 1995 for some of
the variables needed for our analysis. Figure 1 presents the scatter plots for each
year using information on FDI/RGDP and the size of higher education enrollment
 FDI and Skill Formation in China 167

Table 1. Per capita income and FDI (Yuan): 1978–2004

Average Per-Capita Annual Growth FDI Annual

Year Income (Yuan) Rate Year (Billion Yuan) Growth Rate

1978 615 ∼ 1979–1984 7.47 ∼

1980 762 11.95 1985 5.87 −10.71
1985 1,148 10.13 1989 12.8 23.61
1989 1,935 17.14 1990 16.74 30.78
1990 2,140 10.59 1995 313.15 354.13
1991 2,340 9.35 1996 346.70 10.71
1992 2,711 15.85 1997 375.53 8.32
1993 3,371 24.35 1998 376.7 0.31
1994 4,538 34.62 1999 333.67 −11.42
1995 5,500 21.20 2000 336.93 0.98
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1996 6,210 12.91 2001 388.19 15.21

1997 6,470 4.19 2002 436.2 12.37
1998 7,479 15.60 2003 442.82 1.52
1999 8,346 11.59 2004 501.59 13.27
2000 9,371 12.28 1979–2004 3894.36 ∼
2001 10,870 16.00
2002 12,422 14.28
2003 14,040 13.03
2004 16,024 14.13

Source: China Year Book 2005, National Bureau of Statistics of China.

Table 2. Percentage rate of growth of enrollment by regimes by education level

Year Bachelor Masters & PhD Secondary Primary

Growth Rate Growth Rate Growth Rate Growth Rate Growth Rate

1990 −0.92 −5.26 2.13 −4.82

1991 6.89 6.85 1.86 −2.22
1992 16.08 13.39 −0.66 −2.29
1993 10.38 19.82 5.12 −2.02
1994 3.85 13.69 7.81 −2.04
1995 3.94 11.61 6.86 −3.40
1996 5.07 8.64 4.85 −2.65
1997 7.38 12.78 4.71 −3.06

Source: 50-Year Chinese Educational Statistic Database, Ministry of Education of People’s Republic of China,
2005.

where RGDP is the real Gross Domestic Product (GDP) measured using the GDP
deflator for each year. In Figure 1 and Figure 3 (for coastal and non-coastal
regions), we see that the number of provinces having enrollment size less than
50,000 in higher education became smaller over the period.
To estimate the impact of FDI on the human capital we regress higher education
enrollment on FDI and other control variables. The choice of control variables is
guided by the International Trade and Finance literature, which says that foreign
firms want to invest in host countries if conditions are favorable for economic
profit making. The summary statistics are provided in Table 3 where for I we
have used the total funds (available) for state-owned research and development
institution and information and literature institutions at and above county level,
 168 B. Basu & J. Yao
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Figure 1. Scatter plots of FDI/RGDP and enrollment.

Table 3. Summary statistics of all the variables

Standard
Variable Mean Maximum Minimum Median Deviation

I 1.23 m 8.78 m 49.20 th 0.84 m 1.29 m

F 2.57 m 22 m 19.11 th 0.1 m 4.23 m
R&D 0.23 m 1.71 m 8 th 0.11 m 0.32 m
FDI/RGDP 0.072 0.442 0.002 0.038 0.085
RFDI1/RGDP 0.085 0.386 0.006 0.072 0.067
RFDI2/RGDP 0.080 0.475 0 0.056 0.068
RFDI3/RGDP 0.165 0.861 0.008 0.137 0.116
TFDI/RGDP 0.078 0.493 0.002 0.045 0.088
Ed 0.15 m 0.59 m 7.78 th 0.13 m 0.11 m
D 0.35 1 0 0 0.48
ER 0.27 0.7 0.01 0.23 0.14

Source: China Year Book 2005, National Bureau of Statistics of China; Number of observations: 140;
m = million; th = thousand.
 FDI and Skill Formation in China 169

Figure 2. FDI and enrollment over time.

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and for the variable F we have used the basic indicator of registered foreign-funded
enterprise by region at the end of year (total investment).
The variable, R&D, is the total expenditure (actual) for state-owned research
and development institutions and information and literature institutions at and
above county level.4 The actual utilized funds of foreign investment are shown
as FDI; RGDP in Yuan is calculated using GDP deflator for each year; Ed is
defined as the number of students enrolled in higher education (undergraduates
and graduates); the variable D is the dummy for the location of the province;
D = 0 for the coastal provinces and D = 1 for the non-coastal provinces, and ER
is the employment rate. TFDI is the sum of FDI, foreign loans and other foreign
investments, RS is the investment in real estate, RFDI1 is the share of foreign
firms in the total number of firms, RFDI2 is the share of firms from Hong Kong,
Macao and Taiwan in the total number of firms, and RFDI3 is the sum of RFDI1
and RFDI2. Figure 2 represents the trend in FDI and trend in Ed over the years
used in the analysis.

Specification and Estimation Issues

In our specification we tried four different measures of FDI: (1) actual utilized
value of FDI; (2) the sum (called TFDI) of FDI, foreign loans and other forms of
foreign capital; (3) FDI as investment in real estate; and (4) FDI measured as the
ratio of foreign firms in total number of firms. In measuring this ratio, we have
separated the number of investing firms out of Hong Kong, Macao and Taiwan

4 Institutional challenges faced by the Chinese Ministry of Education directed universities to imple-
ment the Chinese Action Scheme for invigorating education towards the 21st century. Most Chinese
universities are state-owned and receive funding from the Government. In recent years, the number
and the size of the universities have increased. The enrollment of both graduate and undergraduate
students has gone up. A lot of these universities, however, have created programs that are funded
privately. The tuition charged to the students has become an important source of university resource.
The Chinese government is now paying attention to research and information institutions to make
sure that they integrate Chinese and Western culture.
 170 B. Basu & J. Yao

from other foreign firms. Formally, our specification is written as:

EDit = (FDI)it + ERit + RDit + FDIit × ERit + FDIit × RDit
+ ERit × Rit D + uit (1)
or
EDit = (TFDI)it + ERit + RDit + TFDIit × ERit + TFDIit × RDit
+ ERit × RDit + uit (2)
or
EDit = (RFDI)it + ERit + RDit + RFDIit × ERit + RFDIit × RDit
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+ ERit × RDit + uit (3)

EDit = (RS)it + ERit + RDit + RSit × ERit + RSit × RDit + ERit × RDit + uit
(4)

where i stands for province and t stands for year.

We chose to provide a panel data analysis, since a big advantage of panel data
analysis is the (likely) reduction of multicollinearity and, especially in our data, it
will be able to control for unobserved heterogeneity for the time-invariant effects.
Table 4 describes the correlation matrix.
We present our estimated coefficients with their standard errors in Table 5. The
dependent variable in Model 1 is FDI/RGDP; in Model 2, the dependent variable
is TFDI/RGDP. The literature on FDI in China argues (Broadman & Sun, 1997)
that a large portion of FDI in China has gone to real estate investment. In Model 3,
the dependent variable is foreign investment in real estate only. Model 4 is Model
1 with interaction terms and Model 5 is Model 2 with interaction terms. We
see (Table 5) that FDI as a percentage of RGDP has a favorable effect on higher
education and the effect is significant at the 1% level. The employment rate,
ER, does not have a significant effect and R&D has a negative effect, which is
significant at the 1% level. One plausible explanation is that the volume of R&D
was small in the provinces where foreign investors were already investing. The
FDI may have crowded out the domestic investments. Another implication is that
as the size of the government or state becomes big, people lose interest; however,

Table 4. Correlation matrix

LOGFDIRGDP LOGER LOGED LOGRD

LOGFDIRGDP 1 0.272 0.237 −0.365

LOGER 0.272 1 −0.054 0.123
LOGED 0.237 −0.0539 1 0.869
LOGRD −0.365 0.123 0.869 1
LOGTFDIRGDP 1 0.321 0.089 0.265
LOGER 0.321 1 −0.054 0.123
LOGED 0.089 −0.054 1 0.869
LOGRD 0.265 0.123 0.869 1
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Table 5. Within and between estimation for all provinces of China

Fixed Effect Random Effect

Model 1 Model 2 Model 3 Model 4 Model 5 Model 1 Model 2 Model 3 Model 4 Model 5

FDI/RGDP 0.281∗∗∗ 0.018

(0.066) (0.068)
TFDI/GGDP 0.274∗∗∗ 0.303∗∗∗ 0.045 1.194
(0.040) (0.059) (0.076) (0.489)
Real Estate 1.598∗∗∗ 0.804
(0.190) (0.584)
FDR 0.466∗∗∗ −0.269∗∗∗ −0.490∗∗∗ −0.173
(0.044) (0.056) (0.104) (0.288)
−0.186∗∗∗ −0.326∗∗∗ −0.471∗∗∗ −0.849∗∗∗

FDI and Skill Formation in China 171

FDD
(0.065) (0.065) (0.107) (0.183)
ERD −0.329∗∗∗ 0.167∗∗∗ 0.148 0.303
(0.058) (0.062) (0.112) (0.211)
ER 0.136 0.099 0.039 – – 0.342∗ 0.321∗ 0.334∗ – –
(0.084) (0.076) (0.072) (0.183) (0.185) (0.173)
RD −0.516∗∗∗ −0.487∗∗∗ −0.414∗∗∗ – – −0.62∗∗∗ −0.626∗∗∗ −0.612∗∗∗ – –
(0.048) (0.042) (0.043) (0.066) (0.063) (0.057)
Observations 140 140 140 140 140 140 140 140 140 140
Rˆ2 0.696 0.51 0.784 0.695 0.75 0.816 0.818 0.829 0.64 0.60
F-Tests (P Values) 0.000∗∗∗ 0.000∗ 0.000∗∗∗ 0.000 0.000
∗ Significant at 10%, ∗∗ Significant at 5%, ∗∗∗ Significant at 1%.
 172 B. Basu & J. Yao
Table 6. China provinces

A. Province B. Province

AH ANHUI JS JIANGSU GX GUANGXI (ZHUANG)

FJ FUJIAN JX JIANGXI
GS GANSU JL JIUN NM NEI MONGGOL
(MONGOLIA) (9)
GD GUANGDONG LN LIAONING NX Nf4GXIA OM
GZ GUIZHOU QH QINGHAI XJ XINJIANG (UYGUR)
RED HERE SN SHAANXI XZ XIZ.ANG
HL HEILONGJIANG SD SHANDONG
HEN HENAN SX SHANXI C. MUNICIPALITY
HB HUBEI SC SICHUAN BJ BEIJING
HB HUNAN SH SHANGHAI
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TJ TIANJIN

Source: Demurger et al. (2002).

at the same time people may have competed for drawing FDI in a particular
region.
We performed the Hausman test to rationalize the fixed effect estimation. In the
analysis of random effect, none of the independent variables were at all significant
except the R&D variable. In fixed effect estimates, the coefficients for FDI and
TFDI are not significant. For all five models we reject the null of random effect.
For Model 1, the chi-square statistic turns out to be 128.7 yielding a p-value of
0.000 and for Model 2, it is computed as 209.76 with an associated p-value of
0.000 as well. The corresponding chi-square statistics for Model 3, Model 4 and
Model 5 are 19.93, 902.02 and 1424.08. Thus, we chose to rely on the fixed effect
estimators.
Since market reform policy has worked better for China’s coastal regions com-
pared to that in non-coastal regions in the early years of the reform era (Tang,
2002), we separated all the provinces into two groups (see Table 6). In Tables 7
and 8 we present the separate analysis for coastal and non-coastal provinces. The
effect of FDI is positive for both the coastal and the non-coastal provinces for the
majority of the models. In our estimation for coastal provinces, the employment
rate has a significant negative effect and R&D has a significant positive effect for
Model 3. The p-values for all the models are 0.000 except that of Model 5. The
chi-square values are reported in parenthesis. Because of the p-values we reject
the null of random effects and chose to report fixed effects estimation values for
first four models and we report both fixed effect and random effect (Rn. Effect)
results for Model 5. Since we could not reject the null of random for Model 3 in
Table 8 (Non-coastal Provinces), we have included the random effect results for
Model 3 in Table 8.
Immediately after 1978, when China’s reform policy takes effect, China has
tried to attract foreign investment in the coastal provinces. However, the Chinese
government later has shifted its focus to the non-coastal provinces, which were
lagging behind the coastal provinces in terms of growth. It is interesting to note
that in random effect estimation, the coefficient of FDI is not significant except
Model 4 and Model 5 for the coastal region.
 Table 7. Within and between regression for coastal provinces
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Coastal
Fixed Effect Random Effect
Rn. Effect
Model 1 Model 2 Model 3 Model 4 Model 5 Model 5 Model 1 Model 2 Model 3 Model 4 Model 5

FDI/RGDP 0.190∗∗ 1.110∗∗∗ −0.327 0.655∗

(0.084) (0.224) (0.212) (0.304)
TFDI/GGDP 0.231∗∗∗ 0.962∗∗∗ 0.874∗∗∗ −0.190 0.667∗
(0.048) (0.147) (0.111) (0.274) (0.277)
Real Estate 1.075∗∗∗ −1.30
(0.298) (1.281)
FDR −0.300 −0.321∗∗ −3.29 −0.136 −0.149
(0.186) (0.148) (0.100)∗∗∗ (0.392) (0.357)

FDI and Skill Formation in China 173

FDD −0.538∗∗∗ −0.494∗∗∗ −0.425 −0.347∗ −0.331∗∗
(0.086) (0.065) (0.065)∗∗∗ (0.166) (0.157)
ERD 0.337∗∗ 0.296∗∗∗ 0.263 0.011 −0.002∗
(0.139) (0.103) (0.091)∗∗∗ (0.125) (0.114)
ER 0.104 0.053 −0.229∗∗ – – 0.341 0.332 0.601∗∗ – –
(0.112) (0.101) (0.107) (0.246) (0.279) (0.220)
RD −0.691∗∗∗ −0.609∗∗∗ 0.379∗∗∗ – – −0.375∗∗ −0.491∗∗ −0.800∗∗∗ – –
(0.084) (0.075) (0.050) (0.153) (0.147) (0.128)
Observations 90 90 90 90 90 90 90 90 90 90
R2 0.645 0.715 0.843 0.894 0.914 0.94 0.781 0.752 0.945 0.849 0.97
F-tests 0.000 0.000 0.000 0.000
(p-values) (57.07) (76.35) (105.26) (45.41) (−3.05)
∗ Significant at 10%, ∗∗ Significant at 5%, ∗∗∗ Significant at 1%.
 174
B. Basu & J. Yao
Table 8. Within and between regression for non-coastal provinces
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Non-coastal
Fixed Effect Random Effect
Rn. Effect
Model 1 Model 2 Model 3 Model 3 Model 4 Model 5 Model 1 Model 2 Model 3 Model 4 Model 5

FDI/RGDP 0.419∗∗∗ 0.098 0.151 0.332∗∗

(0.094) (0.116) (0.155) (0.140)
TFDI/GGDP 0.409∗∗∗ 1.721∗∗∗ −0.339∗∗∗ 0.160 −0.380∗∗
(0.084) (0.237) (0.049) (0.155) (0.136)
Real Estate 0.153∗∗∗ 1.495
(0.034) (1.043)
FDR 0.450∗∗∗ −0.113 0.181∗∗ −0.177
(0.082) (0.073) (0.095) (0.102)
FDD −0.357∗∗∗ 0.451∗∗∗ 0.345∗∗∗ −0.486∗∗∗
(0.076) (0.061) (0.060) (0.068)
ERD 0.0005 −0.346∗∗∗ 0.104 −0.156 0.289∗∗
(0.077) (0.085) (0.069) (0.079) (0.086)
ER 0.205∗∗ 0.185∗ −0.04 −0.537∗∗∗ – – 0.425 0.415 0.201∗∗ – –
(0.101) (0.099) (0.090) (0.045) (0.258) (0.258) (0.244)
RD −0.391∗∗∗ −0.384∗∗∗ −0.503∗∗∗ – – −0.670∗∗∗ −0.669∗∗∗ −0.650∗∗∗ – –
(0.043) (0.042) (0.069) (0.072) (0.071) (0.100)
Observations 50 50 50 50 50 50 50 50 50 50
R2 0.862 0.87 0.784 0.652 0.781 0.945 0.946 0.776 0.952 0.959
F-Test (p-values) 0.000 0.000 0.000 0.000
(33.87) (30.88) (−45.36) (57.08) (76.39)
∗ Significant at 10%, ∗∗ Significant at 5%, ∗∗∗ Significant at 1%.
 FDI and Skill Formation in China 175

Table 9. Fixed effect estimation using the ratio of foreign firms to total firms

Fixed Effect Random Effect

Model A Model B Model C Model A Model B Model C

Foreign/Total Firms 0.422∗∗∗ 0.137

(0.027) (0.119)
Hong, Macao, Taiwan/ 0.007 −0.001
Total Firms (0.067) (0.086)
Foreign and Hong Kong/ 0.599∗∗∗ 0.060
Total Firms (0.051) (0.116)
ER −0.035 0.197 ∗∗ −0.003 0.372 ∗ 0.352 ∗ 0.364∗
(0.052) (0.089) (0.061) (0.175) (0.180) (0.179)
RD −0.264∗∗∗ −0.607∗∗∗ −0.408∗∗∗ −0.620∗∗∗ −0.612∗∗∗ −0.621∗∗∗
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(0.034) (0.047) (0.035) (0.058) (0.062) (0.061)

Observations 140 140 140 140 140 140
Rˆ2 0.891 0.645 0.845 0.825 0.816 0.818
P Value 0.000 0.000 0.000
(p-values) (82.62) (52.7) (20.75)
F-Test
∗ Significant at 10%, ∗∗ Significant at 5%, ∗∗∗ Significant at 1%.

The Chinese Yearbook also reports FDI measured as the ratio of foreign firms
in total number of firms. In measuring this ratio, we have separated the number
of investing firms out of Hong Kong, Macao and Taiwan from other foreign
firms. In Table 9, Model A is a regression of enrollment on the ratio of foreign
firms (excluding Hong Kong, Macao and Taiwan) to the total number of firms
and other variables, Model B is a regression of enrollments on the ratio of firms
from Hong Kong, Macao and Taiwan to the total number of firms, and other
independent variables.
Model C shows the relationship between enrollments on the ratio of all foreign
firms including Hong Kong, Macao and Taiwan to total number of firms and
other independent variables.
Finally, in Figure 4 we present the flow of foreign funds in different forms and/or
from different locations, e.g. FDI = Foreign Direct Investment (billion Yuan);
HMT = Number of Investing Companies from Hong Kong, Macao and Taiwan;
Foreign: Number of Investing Companies From Other Countries; RFDI = Direct
Investment on Real Estate (10 million Yuan); and FFS = Foreign Investment on
Fixed Assets (100 million Yuan).

Causality Test and Sensitivity Analysis

To check whether FDI raises human capital or more investment in human capital
attracts FDI we have used Granger’s Causality test. Using both three period and
four period lag structures we have found that in both cases FDI causes an increase
in human capital (ED). The F-value was 3.80 in the test with a three period lag
structure and it is 24.82 in the test with a four period lag structure.5

5 The detailed results are available from the authors.

 176 B. Basu & J. Yao
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Figure 3. Scatter plots for coastal and non-coastal provinces separately.

To check the robustness of our results we have looked at sensitivity analyses. We

are mainly interested in the robustness of our conclusion that FDI affects human
capital formulation favorably. We present our analysis in Table 10. The basic
results remain the same, e.g. (i) FDI affects human capital formation positively,
(ii) R&D is negatively related to the size of enrollment, and (iii) employment is
positively related to school enrollment. These results hold both with FDI defined
as actual value of foreign investment and with FDI defined as the sum of loans,
foreign direct investment and other forms of flow of foreign capital in the Chinese
economy. When we tried 16 different specifications (eight each for FDI and TFDI),
only four out of 16 cases provide coefficients that are not statistically significant.
 FDI and Skill Formation in China 177

Figure 4. Trend of different types of foreign investments.

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Table 10. Sensitivity analysis

FDI/RGDP TFDI/RGDP RFDI ER R&D

Model 1
1.OLS(Log) 0.163∗ (0.30) – – 0.628∗ (0.089) −0.741∗ (0.034)
2.Random(Log) 0.125(0.043) – – 0.611∗ (0.083) −0.674∗ (0.035)
3.2 Stage 0.226∗ (0.031) – – 0.596∗ (0.083) −0.707∗ (0.036)
4.With Lag 0.193∗ (0.03) – – 0.586∗ (0.078) −0.633∗ (0.038)
5.2 Stage with Lag 0.261∗ (0.034) – – 0.170(0.078) −0.597(0.035)
6.Random with Lag 0.014(0.042) – – 1.042∗ (0.127) −0.344∗ (0.035)
7.Within with Lag 0.024(0.034) – – 1.737∗ (0.118) −0.159(0.031)∗
8.Between with Lag 0.018(0.070) – – 0.291(0.153) −0.163(0.069)
Model 2
1.OLS – 0.084(0.032) – 0.244(0.077) −0.623(0.028)
2.Random Effect (Lag) – 0.198∗ (0.034) – 0.113(0.072) −0.565∗ (0.034)
3.2 Stage – 0.084∗∗∗ (0.022) – 0.244∗∗∗ (0.051) −0.624∗∗∗ (0.018)
4.With Lag – 0.031(0.036) – 0.273∗∗∗ (0.079) −0.609∗∗∗ (0.032)
5.2 Stage with Lag – 0.024(0.026) – 0.277∗∗∗ (0.056) −0.606∗∗∗ (0.022)
6.Random with Lag – 0.056∗∗ (0.026) – 0.968∗∗∗ (0.122) −0.346∗∗∗ (0.034)
7.Within with Lag – 0.034∗ (0.020) – 1.692∗∗∗ (0.115) −0.166∗∗∗ (0.030)
8.Between with Lag – 0.023(0.080) – 0.267∗ (0.156) −0.628∗∗∗ (0.068)
∗ Significant at 10%, ∗∗ Significant at 5%, ∗∗∗ Significant at 1%.

Although the Wu-Hausman test suggests that there is no endogeneity problem,

we have tried the IV approach in lag specification and without lag specification.
In both cases, the conclusions hold. However, they are significant only at 10%
level. The random effect analyses, as expected, produce coefficients that are not
statistically significant, although the nature of the relationship is maintained. We
have also tried to run a regression with time dummies (not reported). The results
are not statistically significant.

Conclusion
As China started to pursue its reformed policies in 1978, trade in both goods
and factors played a crucial role in promoting economic growth. It raised per
 178 B. Basu & J. Yao

capita income level, and resulted in a higher rate of capital accumulation. The
country also started taking an active role in the world’s economic integration by
taking advantage of the revolution in technology, especially the information and
communication system, and became one of the largest outsourced countries.
Its participation in the outsourcing, to some extent, implies that the Chinese
labor market may be fostering skill development. In our effort to find a relation
between the inflow of foreign direct investment and education of the workforce,
we find that, in the late 20th century, China experienced not only accumulation
of financial capital, but also that of human capital. The analyses of coastal and
non-coastal regions separately also show that FDI had a positive effect on both
coastal and non-coastal region’s enrollment during the later part of the 1990s.
Studies in the last few decades have shown that much of the foreign investment in
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China is into real estate. In our analysis this real state investment by foreign firms
also leaves a favorable impact on the enrollment in higher education in China.

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