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Foreign direct investment and environmental pollution in China: A

simultaneous equations estimation

Article in Environment and Development Economics · February 2011

DOI: 10.1017/S1355770X10000380 · Source: RePEc

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Environment and Development Economics 16: 71–92 
C Cambridge University Press 2010
doi:10.1017/S1355770X10000380

Foreign direct investment and environmental

pollution in China: a simultaneous equations
estimation∗

QUN BAO†
Department of International Economics, School of Economics,
Nankai University, Tianjin 300071, China. Email: baoqun@yeah.net

YUANYUAN CHEN
Department of International Economics, School of Economics, Nankai
University, Tianjin 300071, China. Email: Chenyy1982@126.com

LIGANG SONG
Crawford School of Economics and Government, Australian National
University, Canberra, ACT 0200, Australia. Email: ligang.song@anu.edu.au

Submitted February 23, 2009; revised March 29, 2010; accepted September 7, 2010;
first published online 2 November 2010

ABSTRACT. This study investigates the effects of foreign direct investment (FDI) on
emissions of five pollutants in China using a panel data set of 29 provinces over the period
1992–2004. The study applies a simultaneous equations estimation technique to estimate
the scale, technique and composition effects of FDI on China’s overall and regional
pollution emissions. The estimation results show that FDI in general helps reduce
pollution emissions in China, contributing largely to its technique effect. Capturing
both the direct and indirect technique effects improves the accuracy in assessing
the environmental impact of the FDI. The study also finds that the environmental
impacts of FDI vary significantly among different regions and for different pollutants in
China.

1. Introduction
China has been the largest destination for foreign direct investment (FDI)
among all developing countries for a number of years. While it has been
acknowledged that the entry of foreign investment into China significantly
boosts its economy (Cheung and Lin, 2004; Yao, 2006), the environmental
consequences of FDI in China have increasingly attracted attention with

∗
We would like to thank Dr Jane Golley, the two anonymous referees and the
Editor of the Journal for providing useful comments and constructive suggestions
to improve the work. Qun Bao gratefully acknowledges financial support from
the Humanities and Social Science fund of China’s Ministry of Education. We
ourselves are responsible for any errors that may remain.
†
Corresponding author
72 Qun Bao et al.

growing concerns over the deterioration of China’s environment and

pressure for increasing environmental protection. In 2000, the share of FDI
invested in industrial sectors accounted for 63.47 per cent of total FDI (25.84
billion US$), and in 2004 the share increased to 70.95 per cent, indicating
that the majority of FDI is invested in industries from which most of
China’s pollution has been generated. Hence, a question is whether FDI
causes more pollution in China, and if it does, through which channels
does it affect China’s environmental quality?
A popular view of the FDI-pollution nexus is the so-called ‘Pollution
Haven Hypothesis’, by virtue of which developing countries with lower
abatement cost and less stringent environmental regulation usually have
an advantage in attracting pollution-intensive foreign capital. A number of
econometric studies have examined whether differences in environmental
standards in host countries can be a location-specific determinant of foreign
investment (Xu and Song, 2000; Smarzynska and Wei, 2001; Keller and
Levinson, 2002; Eskeland and Harrison, 2003; List et al., 2004; Henderson
and Millimet, 2007).
The environmental consequences of foreign firms in China have also
been studied, and the estimation results generally support that there is
a positive role of FDI in reducing environmental pollution in China. For
example, based on the data of nearly 1000 Chinese firms, Wang and Jin
(2002) explore the differences in controlling pollution of industries with
different types of ownership. They find that foreign-invested enterprises
and collective-owned enterprises have better environmental performances
in terms of both pollution control and emission intensities, while state-
owned enterprises and privately owned enterprises in China are the worst
performers in terms of water pollution emission intensity. These differences
in environmental performances by different firms are, as argued by the
authors, mainly due to the fact that foreign-invested enterprises may adopt
more environmentally friendly technologies in their production. Similarly,
based on city-level data for 260 Chinese cities, Liang (2006) also shows that
the entry of foreign investment helps improve the environmental quality in
China, since a negative relationship is found between FDI and air pollution
in its estimation. The study finds that a 1 per cent increase in FDI decreases
sulfur dioxide intensity by 0.6–0.7 per cent.
However, these studies used a single-equation estimation technique, and
their estimation results may, therefore, be biased because of the presence
of simultaneity. Furthermore, it is difficult to understand the mechanisms
through which foreign investment affects local environmental quality
in China using reduced-form estimation. It is Grossman and Krueger
(1991) who first decomposed the environmental outcomes of the North
American Free Trade Agreement (NAFTA) into three effects: the scale
effect, composition effect and technique effect, and such a method of
decomposition has been widely used in empirical studies on the trade-
environment nexus (Antweiler et al., 2001; Copeland and Taylor, 2004).
We adopt a similar approach and divide the environmental effect of FDI
in China into three effects: the first is the scale effect, which means that
by enlarging local output, foreign investment uses more resources and
hence emits more pollutants. The second is the composition effect, namely
 Environment and Development Economics 73

the entry of foreign firms may affect China’s industrial composition,

depending on the pollution intensity of FDI. FDI can also change the
ratio of factor inputs used in production such as the capital–labour
ratio, depending on the factor intensity of FDI, which in turn affects
the level of pollution. For example, capital-intensive industries usually
generate more pollution emissions than labour-intensive ones. The last
is the technique effect, which implies that foreign firms may bring about
more environmentally friendly techniques, which help ease the emission
intensities of production and at the same time cause some positive spillover
effects resulting from the adoption of cleaner technology by local firms.
Furthermore, if the entry of foreign firms helps improve the productivity
of local firms either through cooperation or spillovers, there will also be a
positive impact on local environmental quality since resources are likely to
be more efficiently utilised, and thereby less pollution will be emitted.
To test the existence of these three effects through which FDI impacts
on China’s level of pollution, this study applies a simultaneous equation
estimation technique using panel data of China’s 29 provinces for
the period 1992–2004. The study not only investigates the overall
environmental consequence of foreign firms, but also aims to understand
the variations in the environmental impact of FDI across different regions
in China. To ensure the robustness of the estimation results, five kinds
of different pollutants are used, including air, water pollution as well
as solid wastes. Our estimation results generally support that there is
a positive role of FDI in reducing pollution emissions in China, which
is consistent with the findings reported in Wang and Jin (2002) and
Liang (2006). However, our study goes a step further by decomposing
the total environmental effect of FDI into the three pollution effects. In
doing so, it enables us to demonstrate that such a positive effect can be
attributed largely to the technique effect associated with the inflows of
FDI. We also further decompose the three pollution effects into both the
direct and indirect effects, and the results of such decomposition help us
understand the specific mechanisms through which the entry of foreign
firms affects China’s environmental quality. While we are not the first ones
to study the environmental consequences of foreign investment applying a
simultaneous equations system, the econometric framework applied in the
study has its own contribution in that it considers the interactions between
foreign investment, pollution emissions and economic development in a
unified analytical framework.1
The study proceeds as follows. Section 2 describes the regional
variations in FDI inflows and environmental performance across China’s
29 provinces. Section 3 introduces the estimation model and Section 4
reports the estimation results. Section 5 concludes.

1
Studies which simultaneously estimate the environmental effect of FDI in China
are rare. An exception is He (2002), who decomposes the impact of FDI on SO2
emission in China into the three effects using China’s city level panel data during
1993–1999, and the estimation results show the entry of FDI helps reduce SO2
emissions.
74 Qun Bao et al.

2. FDI and environmental pollution across provinces in China

The pattern of inflows of FDI to China shows remarkable spatial
variations among different regions (see Appendix 1, available at http://
journals.cambridge.org/EDE). The eastern regions have accounted for a
much larger share of FDI due to the government’s preferential policies,
their favourable geographic location and more developed infrastructure
facilities, while the accumulated FDI inflows into the inland provinces
are much lower. Over our sample period 1992–2004, the mean value of
the share of FDI in the eastern region is as high as 87.84 per cent. By
comparison, the share of total FDI is 9.69 per cent for the nine provinces
in the central regions, and only 2.45 per cent for the western regions. The
mean value of FDI in Guangdong, whose share of FDI is the highest among
China’s 29 provinces, is 11.37 billion US$ during the sample period, which
is double the sum of FDI invested in the 17 inland provinces (5.51 billion
US$).
Despite the fact that foreign investment is highly concentrated in the
eastern provinces, it is inconclusive to say whether the eastern provinces
perform better or worse than inland regions with respect to pollution
emissions in connection with the inflows of FDI. Guangdong, with the
largest average share of 27.5 per cent, ranks the highest in terms of
attracting FDI. However, it demonstrates a pattern of pollution which
is quite similar to that in Hubei, Hunan as well as Guizhou in the
central or western regions. The emission levels of four pollution indicators
in Guangdong – industrial polluted water, chemical oxygen demand
(COD), industrial smoke and industrial solid wastes – have similar mean
values to that in Hubei, but the mean value of FDI in Hubei is less
than one tenth of that of Guangdong. Different provinces within the
same region also perform differently as far as the pattern of pollution is
concerned. Taking the eastern region as an example, four out of the five
pollutants (except COD) demonstrate increasing trends over the sample
period in Guangdong. By comparison, Shanghai performs much better
as its emission levels of three of the four pollutants (except industrial
solid wastes) all decline over the same period. With significant regional
variations in both the FDI inflows and the environmental performance in
China, one needs to ask whether the entry of foreign firms helps reduce
pollution emission and hence improves the local environmental quality.
We aim to investigate the environmental consequences of FDI in China by
using a simultaneous equations estimation method in this study.

3. Model specifications and data

Following Copeland and Taylor (2003), we decompose the emission level
of pollution (polu) into three effects: the scale, composition and technique
effects.2 Gross domestic product (gdp) is widely used to measure the scale
effect. This study adopts the ratio of industrial output to (gdp) to capture
the pollution effect of changes in industrial composition (comp). Finally, the
technique effect (tech) is measured by the ratio of total pollution emissions

2
See Appendix 2 (available at http://journals.cambridge.org/EDE) for a graphic
analysis of the decomposition of the environmental effect of FDI.
 Environment and Development Economics 75

over industrial output, which is essentially the pollution intensity per

unit of industrial output. According to Copeland and Taylor (2003), the
technique effect is not only affected by the pollution tax rate, but also by
other factors, such as technology advancement and R&D expenditures on
environmental protection. Hence, pollution per unit of industrial output
may be a more direct measure of the technique effect. Therefore, pollution
emissions can be decomposed into three effects:
log poluit = log gdpit + log techit + log compit .
Panel data for 29 provinces in China during 1992–2004 are used in
this study. Tibet is excluded from the sample due to data unavailability
for certain indicators. Since Chongqing only became a municipality
city in 1997, we integrate Chongqing’s data into Sichuan province
as a whole. The real value of GDP is calculated by adjusting the
nominal GDP based on GDP indexes across different provinces, and
the ex-factory price indexes of industrial products have also been
used to calculate the real value of industrial output. For the pollution
indicators, five kinds of pollutants are used: industrial sulphur dioxide,
industrial dust, industrial polluted water, industrial solid wastes and
chemical oxygen demand in industrial water pollution (see Appendix 3,
available at http://journals.cambridge.org/EDE, for their definitions).
All the original pollution data are taken from China’s Environmental
Yearbooks.

3.1 The scale effect

To measure the scale effect of FDI, we estimate how FDI affects economic
scale in the following equation:
log gdpit = a 0 + a 1 log fdiit + a 2 log kit + a 3 log lit + a 4 log poluit
+ a 5 log h it + εit ,
where subscripts i and t represent region i and year t, respectively. a i is
the region-specific fixed effect, and εit is the error term with the usual
attributes. The scale equation implies that regional output level (gdpit )
depends essentially on the following variables: (1) Regional physical
capital stock (kit ). Based on Zhang et al. (2004), the commonly used
perpetual inventory method is used to estimate the stock of physical capital
among different regions. (2) Labour input (lit ), which is measured by
employment at the end of each year for each province. (3) Human capital
accumulation (h it ). Educational attainment is widely used to measure the
level of human capital (Barro and Lee, 2001), which is the ratio of the
sum of all employees’ education years to the total population. Specifically,
we set the education attainment of elementary schooling as six years,
and that of junior middle school, senior middle school and university
graduates as 9, 12 and 16 years, respectively. (4) Pollution emission (poluit ).
By introducing pollution emissions into the scale equation, the feedback
effect of environmental pollution on economic growth can be captured.
The coefficient a 4 is expected to be negative, i.e., higher levels of pollution
may negatively affect economic growth because of the damages inflicted by
76 Qun Bao et al.

environmental degradation and the associated costs involved in mending

the damages. (5) Foreign investment (fdiit ), which is measured by actual
utilised FDI for each province. Taking the significant regional disparities
in China into consideration, we add two regional dummies to our growth
accounting model to capture the role of geographic location and regional
income disparities. While dume denotes the dummy variable for the 12
eastern provinces, dumc is our second dummy variable for the nine
provinces in central region. We also add another time variable year to
control for the time trend in China’s regional economic growth.
While the coefficient a 1 measures the direct effect of FDI on economic
growth, FDI may also impact on economic growth by promoting the
accumulation of physical capital kit in host countries, which can be
considered as the indirect effect of FDI on economic growth. Thus, we
also estimate how FDI affects physical capital accumulation through the
following equation:
log kit = di + d1 log fdiit + d2 log(gdpit−1 − gdpi,t−2 ) + μit ,
where μit is the error term and gdpi,t−1 is the one period lagged value of
gdp, so the coefficient d2 measures how physical capital accumulation will
be affected by the macroeconomic environment and economic fluctuations.
We also have dummy variables di incorporated in the model to measure
individual region-specific fixed effect. As FDI is also a part of physical
capital formation in host countries, the coefficient d1 depends on how the
entry of foreign firms affects local firms’ investment decisions, namely
whether there is a crowding-in or crowding-out effect of FDI on domestic
investment.

3.2 The technique effect

The technique effect equation reads as follows:
log techit = b 0 + b 1 log prdit + b 2 log numit + b 3 log fdiit + b 4 log densit
+ b 5 log agdpit + b 6 budit + b 7 govit + υit ,
where υit is the error term. It can be seen that the technique effect
tech, measured by pollution emissions per unit of industrial output, is
determined by the following variables: (1) R&D expenditures in pollution
abatement (prdit ), which captures the undertaking of host countries in
reducing environmental pollution, so the coefficient of prdit is expected
to be negative. (2) The number of employees in environmental protection-
related agencies at different administrative levels (national, provincial and
metropolitan levels), which is denoted as numit . The role of environmental
protection-related employees is similar to prdit , which captures the
pollution abatement efforts made in host countries, and so the coefficient
of numit is also expected to be negative. The original data of prdit and
numit are taken directly from the China Environment Yearbooks. (3)
Government pollution abatement expenses. In the China Environment
Yearbook, two types of government pollution abatement expense are listed.
One is the state budget of governments’ pollution abatement, and the
other is the special funds for pollution abatement. Both indicators of
 Environment and Development Economics 77

government pollution abatement expense are adopted here as they are

mutually exclusive: budit stands for state pollution abatement budget, and
govit for special pollution abatement expense funds. (4) Population density
(densit ) is the number of people per square kilometre. It is argued that the
larger the population density is, the more damage pollution emissions are
likely to cause prompting more efforts to be made in reducing the intensity
of pollution emissions. So we expect b 2 to be negative. The original data
on population densities are taken from China’s Statistical Yearbook. (5)
GDP per capita (agdpit ), which measures the stage of regional economic
development and affects pollution emission per unit of industrial output
in two ways. First, a higher GDP per capita means that people have a
higher demand for cleaner environment (assuming that the environment is
a normal good), compelling the government to implement more stringent
environment regulations. Second, a higher GDP per capita also implies
a more advanced stage of regional economic development; hence more
resources can be allocated into environment protection and pollution
abatement activities. So the technique effect of GDP per capita is expected
to be negative in the model estimation.
We also add two regional dummy variables to capture regional
variations in pollution emission intensities. One is dume for the 12
provinces in eastern region. The other is the dummy variable dums for the
two provinces in inland China, i.e., Shanxi and Neimenggu, as both of them
are well endowed with coal.3 A time variable year is also used to control
for the time trend in pollution per unit of industrial output.

3.3 The composition effect

The composition effect equation is given as follows:
 
k
log compit = c 0 + c 1 log fdiit + c 2 log trdit + c 3 log + c 4 log agdpit
l it
+ c 5 log railit + c 6 log roadit + νit ,
where νit is the error term. The equation demonstrates that industrial
composition, denoted by the ratio of regional industrial output to its GDP,
is affected by: (1) R&D expenditure (trdit ), which plays an important
role in the adjustment of regional industrial structure by promoting the
advancement of technology and innovation. (2) Ratio of factor inputs,
which is measured by the ratio of physical capital stock to labour.
Generally, a higher ratio of capital–labour will lead to a larger share of
industrial output in the economy and therefore tend to produce more

3
The reason why we particularly use the dummy variable dums for Shanxi and
Neimenggu is based on the fact that coal has been the basic energy consumption
in China’s industrial activities, and the development of coal sector plays a much
more important role in the two provinces than other region. In other words,
the industrial development in the two provinces is highly coal dependent. For
example, in 2004 the shares of coal sector to total industrial output are 24.47 and
9.38 per cent for Shanxi and Neimenggu, respectively, which are much higher
than that in other regions.
78 Qun Bao et al.

pollution. (3) GDP per capita (agdpit ), which will affect the composition
effect in two ways. First, a higher GDP per capita reflects a rapid process
of industrialisation, which tends to generate more pollution. Second, a
higher GDP per capita also implies that people have a higher demand for
a cleaner environment and environmentally friendly products. Hence, the
combined composition effect of GDP per capita on pollution is ambiguous.
(4) Two infrastructure variables railit and roadit , measured by the lengths
of railway and road in kilometres, respectively, are also used to measure
the role of infrastructure development in industrial activities. We also add
two regional dummies: dume for the 12 eastern provinces and dums for the
two inland provinces of Shanxi and Neimenggu, as well as a time-trend
variable year.

3.4 The determinants of FDI inflows in China

One of the problems in estimating the econometric models applied in
the study lies in the endogeneity of foreign investment, meaning that the
location choice of foreign-invested firms may essentially depend on certain
economic factors. To deal with the endogeneity problem of FDI, we follow
other studies such as Cheng and Kwan (2000), Sun et al. (2002) and Gao
(2005), to examine the determinants of FDI by establishing the following
model:
log fdiit = γ0 + γ1 log fdii,t−1 + γ2 log wageit + γ3 log rail + γ4 log roadit
+ γ5 log polui,t−1 + ηit ,
where log fdii,t−1 is FDI lagged by one year, and the coefficient γ1 measures
whether there is a self-accumulation effect of foreign investment. We also
use other standard explanatory variables in the model: (1) wageit is the
average wage for province i, which captures the role of labour costs
in attracting foreign investment into China. (2) The two infrastructure
variables railit and roadit , denote the lengths of the railway and road in
kilometres, respectively. (3) We also have two regional dummy variables
included to capture the regional disparity in attracting FDI: dume for
the 12 provinces in eastern China and dumc for the nine provinces in
central China, and year is used to control for the time trend in FDI
inflows.
Finally, we attempt to investigate further whether the level of pollution
emission also significantly affects foreign investors’ decision on investing
in different provinces, as implied by the ‘pollution haven hypothesis’. To
do so, we add another explanatory variable polui,t−1 , which is the lagged
term of pollution emissions by one year, to measure the feedback effect of
environmental pollution on foreign firms’ location choices.

3.5 The simultaneous equations model

In sum, we have established an econometric system consisting of six
equations to simultaneously estimate the effect of FDI on pollution
emissions in China as follows:
log poluit = log gdpit + log techit + log compit , (1)
 Environment and Development Economics 79

log gdpit = a 0 + a 1 log fdiit + a 2 log kit + a 3 log lit + a 4 log poluit + a 5 log h it
+ εit , (2)

log techit = b 0 + b 1 log prdit + b 2 log numit + b 3 log fdiit + b 4 log densit
+ b 5 log agdpit + b 6 budit + b 7 govit + υit , (3)
 
k
log compit = c 0 + c 1 log fdiit + c 2 log trdit + c 3 log + c 4 log agdpit
l it
+ c 5 log railit + c 6 log roadit + νit , (4)

log kit = di + d1 log fdiit + d2 log(gdpit−1 − gdpi,t−2 ) + μit , (5)

log fdiit = γ0 + γ1 log fdii,t−1 + γ2 log wageit + γ3 log rail + γ4 log roadit
+ γ5 log polui,t−1 + ηit . (6)
Equation (1) is an identity, which decomposes pollution emissions into
the three effects. Equations (2)–(4) are the scale, technique and composition
effect equations, respectively. Equation (5) estimates how FDI contributes
to physical capital accumulation in China. Equation (6) investigates the
determinants of FDI in China to deal with the endogeneity problem
associated with the determinants of FDI inflows.
The above simultaneous equations system demonstrates the mech-
anisms through which the entry of foreign firms may affect pollution
emissions in host countries (see Appendix 4, available at http://
journals.cambridge.org/EDE, for a schematic description about how these
mechanisms work). First, FDI affects pollution emission directly through
the three effects, which can be measured by the coefficients a 1 , b 3 and
c 1 , respectively. Second, as pollution intensity and industrial composition
also change with economic development, FDI has an indirect impact on
pollution emissions through its impact on GDP per capita, and this indirect
effect is jointly determined by a 1 and b 5 (c 4 ). Third, FDI has another indirect
effect on pollution emissions through its impact on capital accumulation,
since the latter also affects both the scale and composition effects. Finally,
the feedback effect of pollution emissions on economic growth is also
considered.

4. Estimation results
Since equation (1) is an identity, we only need to estimate the other
five equations. The system consisting of equations (2)–(6) can be studied
using the usual rank and order conditions, and it is obvious that all five
equations are overidentified. Generally, system estimation methods such
as two-stage least squares (2SLS) and three-stage least squares (3SLS) can
be used to estimate the econometric models. It is well known that 3SLS
is more efficient than 2SLS in that 3SLS permits correlations between the
unobserved disturbances across different equations, as well as restrictions
among coefficients of different equations, and hence improves upon the
efficiency of equation-by-equation estimation by taking into account such
80 Qun Bao et al.

Table 1. Estimation results on the scale effect

(log gdpit )

so2it smokeit waterit solidit codit

a −2.443c −1.709c −2.632c −2.352b −1.820b

(0.336) (0.345) (0.306) (0.315) (0.382)
log fdiit 0.145c 0.181c 0.119c 0.183c 0.147c
(0.015) (0.014) (0.014) (0.014) (0.016)
log kit 0.329c 0.304c 0.319c 0.287c 0.331c
(0.028) (0.026) (0.025) (0.026) (0.028)
log lit 0.502c 0.352c 0.279c 0.360b 0.372b
(0.034) (0.034) (0.034) (0.031) (0.037)
log h it 0.927c 0.646c 0.618c 0.708c 0.809c
(0.170) (0.166) (0.154) (0.159) (0.175)
log poluit −0.009 0.157c 0.241c 0.146c 0.121c
(0.022) (0.022) (0.029) (0.019) (0.021)
dume −0.234c −0.230c −0.249c −0.273c −0.276c
(0.053) (0.052) (0.049) (0.052) (0.057)
dumc −0.038 −0.053 −0.039 −0.081b −0.059b
(0.043) (0.041) (0.039) (0.041) (0.043)
year −0.048c −0.041c −0.033c −0.049c −0.043c
(0.004) (0.004) (0.004) (0.004) (0.005)
a d j − R2 0.930 0.933 0.939 0.934 0.932
sample 377 377 377 377 377

Note: The numbers in parentheses are standard errors. c and b indicate

the significance at 1 and 5 per cent level, respectively.
Source: Authors’ own estimation.

correlations across equations (Wooldridge, 2002). Therefore, we adopt the

3SLS method to estimate the above econometric system consisting of the
five equations.

4.1 Estimation results for the scale effect

Table 1 shows the estimation results for the scale effect. First, physical
capital, labour and human capital are all important sources of economic
growth, and the role of human capital is more significant than the
other two factors. This finding is consistent with the general belief that
China’s economic growth is mainly driven by factor accumulation. Second,
table 1 also captures the feedback from pollution emissions to economic
growth. The coefficient is estimated to be significantly positive for all four
pollutants except so2it . Regarding pollution emissions as another factor
input like capital and labour (Copeland and Taylor, 2003), our results
indicate that the elasticity of pollution emissions roughly ranges between
0.12–0.24.
Third, table 1 implies that foreign investment is also an important
driving force for economic growth apart from domestic factor inputs, since
a 1 is estimated to be significantly positive in all five equations. The output
elasticities of FDI are about 0.12–0.18, which are lower than that of physical
 Environment and Development Economics 81

Table 2. Estimation results on the capital accumulation effect

(log kit )

so2it smokeit waterit solidit codit

log fdiit 0.075c 0.066c 0.075c 0.067c 0.127c

(0.012) (0.012) (0.012) (0.012) (0.017)
log gdpcit −0.133 −0.090 −0.103 −0.109 −0.145
(0.116) (0.116) (0.115) (0.115) (0.105)
year 0.114c 0.115c 0.115c 0.115c 0.114c
(0.002) (0.002) (0.002) (0.002) (0.002)
region yes yes yes yes yes
a d j − R2 0.989 0.989 0.989 0.989 0.991
sample 377 377 377 377 377

Note: The numbers in parentheses are standard errors. c indicates the

significance at 1 per cent level.
Source: Authors’ own estimation.

capital, labour and human capital in contributing to growth as one would

expect. However, the role of FDI in contributing to China’s economic
growth could be larger if one takes into account the role of FDI in China’s
domestic capital accumulation. The coefficients of FDI range between 0.06–
0.07, meaning that physical capital stock will increase by 0.06–0.07 per cent
with a 1 per cent increase of FDI (table 2). Finally, if we combine both the
direct and indirect effects of FDI on economic growth, it is found that the
total effect of FDI on China’s economic growth will be a 1 + d1 a 2 . Taking
SO2 as an example, the total scale effect of FDI is around 0.145 + 0.329 ×
0.075 = 0.169.

4.2 Estimation results for the technique effect

Table 3 shows the estimation results for the technique effect for the
five pollutants. The coefficients of prdit are all significantly negative,
indicating that R&D expenditures on pollution abatement activities,
cleaner technology, updating of traditional production techniques and
equipment all help reduce pollution emissions. However, the coefficient
of num is estimated to be significantly positive. This finding is contrary
to our prior expectation as a larger number of personnel employed
in environmental agencies usually mean more efforts have been made
regarding environmental regulation and its implementation. This may
be due to the two-way causality between environmental agencies and
pollution emissions. While more personnel in environmental agencies and
organisations imply that more stringent environmental regulations are
put in place and more abatement efforts are made, it is also possible
that for those regions with higher levels of pollution emissions and
poorer environmental quality, more personnel in environmental agencies
are required to be employed to monitor and control firms’ pollution
behaviour. This two-way causality between agcy and pollution emissions
82 Qun Bao et al.

Table 3. Estimation results on the technique effects

(log techit )

so2it smokeit waterit solidit codit

b 7.752c −0.866a 3.722c 2.443c −4.111c

(0.386) (0.443) (0.307) (0.453) (0.563)
log prdit −0.134c −0.152c −0.021 −0.077c −0.126c
(0.025) (0.029) (0.019) (0.029) (0.038)
log numit 0.226c 0.312c 0.308c 0.271c 0.242b
(0.056) (0.063) (3.496) (0.065) (0.098)
log fdiit −0.381c −0.323b −0.154b −0.304a −0.127b
(0.034) (0.039) (0.027) (0.040) (0.056)
log densit 0.098c −0.197b −0.087c −0.147c −0.113b
(0.037) (0.042) (0.029) (0.043) (0.055)
log agdpit −0.604c −0.354c −0.618c −0.397c −0.617b
(0.081) (0.093) (0.064) (0.095) (0.167)
log budit 0.070c 0.017 0.024 0.042 −0.016
(0.022) (0.025) (0.017) (0.026) (0.032)
log govit 0.057b 0.083c −0.0006 0.078c 0.091c
(0.022) (0.024) (0.017) (0.025) (0.031)
dume 0.314c −0.102 −0.263c −0.086 0.130
(0.087) (0.101) (0.071) (0.103) (0.137)
dums 0.774c 0.413c −0.239c 0.604c 0.0004
(0.117) (0.136) (0.092) (0.139) (0.172)
year 0.0002 −0.006 −0.085c 0.035c −0.069c
(0.009) (0.011) (0.007) (0.011) (0.014)
adj − R2 0.694 0.703 0.644 0.621 0.520
sample 377 377 377 377 377

Note: The numbers in parentheses are standard errors. c,b and a indicate
the significance at 1, 5 and 10 per cent level, respectively.
Source: Authors’ own estimation.

could make their relationship appear ambiguous.4 We have also observed

the similar estimation results in estimating the two government pollution
abatement expenses. While the coefficient of the state pollution abatement
budget is estimated to be statistically insignificant, that of special pollution
abatement expense funds is significantly positive except for industrial
polluted water, which may also indicate that more abatement expense

4
To capture such two-way causality between pollution emission and environ-
mental regulation, we also attempt to use the emission level of other pollutants
as the instrument variable to deal with the possible endogeneity problem of
personnel in environmental agency. For example, while we estimate the technique
effect for SO2 , we use industrial waste water emission as the instrument variable
for personnel in environmental agency, since there is no significant correlation
between emission levels of different pollutants. However, the coefficient of agcy
is still insignificant in our IV estimation results.
 Environment and Development Economics 83

is required to deal with pollution problems for those regions with a

worsening environmental quality.
Second, the coefficient of population density is estimated to be negative
and statistically significant for all five pollutants. This finding is consistent
with the theoretical proposition as derived in Copeland and Taylor (2003).
As population density rises, the marginal pollution damage inflicted also
becomes larger, so more stringent environmental regulation is required
by the local residents. Similarly, the coefficient of GDP per capita is
significantly negative, suggesting that China is ‘over the hump’ of the
environmental Kuznet’s curve.
Third, as for the technique effect of FDI, the coefficients of fdi are all
significantly negative ranging between −0.12 and −0.38, suggesting that
the pollution emission intensity decreases by 0.12–0.38 per cent with a 1
per cent increase of FDI. This is mainly because it is more likely for foreign
firms to have adopted more environmentally friendly techniques or those
technologies which are more advanced in general than that of local firms
in their production, contributing to the reduction of pollution emissions
(confirming the findings by Wang and Jin, 2002). This may also be due to
the fact that technology spillover effects emanating from foreign firms to
domestic firms help improve local firms’ efficiency of utilising energy and
resources and thereby lower the pollution emission intensity of production
in general.

4.3 Estimation results for the composition effect

The estimation results for the composition effect for the five pollutants are
reported in table 4. First, factor inputs, measured by the ratio of capital–
labour, are an important determinant of the industrial composition. The
positive coefficient of k/l indicates that a relatively high capital–labour ratio
will lead to a larger share of industrial output in the economy, and because
industrial sectors are in general typically capital intensive and pollution
intensive (Antweiler et al., 2001), this will consequently lead to a higher
level of pollution. Second, R&D expenditures also have a positive impact
on industrial development. Specifically, the share of industrial output will
increase by 0.1 per cent with a 1 per cent increase in R&D. Since for a long
time most R&D and innovation activities have taken place in industrial
sectors in China, it is reasonable to expect a positive role of R&D in
enhancing industrial growth. The effect of GDP per capita is estimated to
be significantly negative, implying that as per capita income increases, the
industrial composition tends to change towards developing those cleaner
or more value added products and services.
Second, the composition effect of FDI is found to be significantly
positive. According to the results reported in table 4, a 1 per cent increase
of FDI will cause the share of industrial output in the total economy to
increase by 0.1–0.15 per cent. Since the majority of foreign-invested firms
have been concentrated in the industrial sector, the contribution of FDI
to the increase in industrial output in China is understandable. However,
to assess the role of FDI in influencing the industrial composition more
accurately, we need to further consider that foreign investment has an
indirect impact on industrial composition by affecting the capital–labour
84 Qun Bao et al.

Table 4. Estimation results on the composition effects

(log compit )

so2it smokeit waterit solidit codit

c −0.988c −0.648b −0.393c −0.684b −1.237c

(0.318) (0.312) (0.318) (0.314) (0.324)
log fdiit 0.139c 0.124c 0.097b 0.124b 0.156c
(0.018) (0.018) (0.018) (0.018) (0.020)
log trdit 0.099c 0.093c 0.103c 0.096c 0.068c
(0.015) (0.015) (0.015) (0.015) (0.015)
log (k/l)it 0.271c 0.149c 0.100b 0.153b 0.163b
(0.045) (0.043) (0.045) (0.044) (0.046)
log agdpit −0.547c −0.379c −0.192b −0.384c −0.340c
(0.086) (0.083) (0.086) (0.084) (0.088)
log railit 0.030 0.056b −0.024 0.055b 0.011
(0.028) (0.026) (0.028) (0.027) (0.028)
log roadit −0.207c −0.229c −0.144c −0.227c −0.172c
(0.038) (0.036) (0.038) (0.037) (0.039)
dume 0.108a 0.162c 0.145b 0.158c 0.101a
(0.058) (0.057) (0.058) (0.057) (0.060)
dums 0.037 0.086 0.058 0.084 0.069
(0.079) (0.079) (0.080) (0.079) (0.081)
year 0.009 0.023c 0.024c 0.023c 0.036c
(0.007) (0.007) (0.007) (0.007) (0.008)
adj − R2 0.595 0.578 0.576 0.579 0.626
sample 377 377 377 377 377

Note: The numbers in parentheses are standard errors. c,b and a indicate
the significance at 1, 5 and 10 per cent level, respectively.
Source: Authors’ own estimation.

ratio and through which economic growth. To do so, we will calculate the
combined environmental effects of FDI in the next section.

4.4 Estimation results for the determinants of FDI in China

Table 5 reports the estimation results for the determinants of FDI in
China. Generally, the estimation results are consistent with those findings
from the studies by Cheng and Kwan (2000); Sun et al. (2002) and Gao
(2005). A remarkable self-accumulation effect of FDI is found, as the
coefficient of fdii,t−1 is significantly positive, indicating that a higher value
of FDI in previous years tends to attract more foreign capital flowing into
China, possibly due to the geographic agglomeration effect. The positive
coefficient of road reveals the importance of infrastructure in attracting
FDI; however, this is not the case for rail. While the coefficients of the two
regional dummy variables, dume and dumc are estimated to be significantly
positive, the estimated coefficient of dume is much larger in terms of its
magnitude than that of dumc. This finding is consistent with the regional
distribution of FDI in China with a much higher concentration of FDI being
 Environment and Development Economics 85

Table 5. Estimation results on the determinants of FDI

(log fdiit )

so2it smokeit waterit solidit codit

c −2.768b −2.573b −1.434 −2.223a −0.839a

(1.331) (1.340) (1.215) (1.297) (1.304)
log fdii,t−1 0.699c 0.711c 0.629c 0.703c 0.786c
(0.024) (0.023) (0.023) (0.023) (0.026)
log wage 0.523c 0.568c 0.334b 0.518c 0.291b
(0.148) (0.156) (0.136) (0.145) (0.149)
log railit −0.055c −0.033c −0.069b −0.083b 0.007
(0.042) (0.041) (0.036) (0.043) (0.039)
log roadit 0.181b 0.184b 0.025 0.153c 0.116b
(0.043) (0.043) (0.043) (0.043) (0.045)
log polui,t−1 0.069b 0.002b 0.326c 0.122c 0.001
(0.031) (0.001) (0.036) (0.035) (0.001)
dume 0.908c 0.868c 0.867c 0.865c 0.694c
(0.093) (0.093) (0.086) (0.091) (0.101)
dumc 0.563c 0.521c 0.456c 0.493c 0.398c
(0.078) (0.077) (0.071) (0.076) (0.078)
year −0.112b −0.121c −0.059c −0.115c −0.078c
(0.020) (0.021) (0.019) (0.019) (0.019)
adj − R2 0.940 0.939 0.944 0.941 0.940
sample 377 377 377 377 377

Note: The numbers in parentheses are standard errors. c,b and a

indicate
the significance at 1, 5 and 10 per cent level, respectively.
Source: Authors’ own estimation.

invested in the eastern provinces. However, the effect of wages on FDI is

estimated to be unexpectedly positive.5
The study continues to examine whether there is a feedback effect of
pollution emissions on FDI. The pollution haven hypothesis supposes
that developing countries have comparative advantages in those polluting
sectors due to their relatively lower environmental standards. The
Chinese experience provides an interesting case for examining whether
environmental quality matters in attracting FDI. Our estimation results
support, to a certain extent, the pollution haven hypothesis in that the

5
We also try to use two more indicators proxying for wages. One is the 1
year lagged term of wage, and the other is the average wage for industrial
workers. However, the estimation results show that the coefficients of two
variables are both statistically insignificant, which may imply that the role of
labour cost in attracting FDI is ambiguous. For example, higher wage may
indicate higher labour quality, which helps attract more FDI, especially, in those
high technology areas. The sources of foreign investment may also matter in
determining the outcomes, for example, whether foreign investors come from the
Asian developing economies or western developed economies as the latter bring
in more advanced technology and therefore require higher quality of labour force.
86 Qun Bao et al.

coefficients of the lagged term of pollution emission are estimated to be

positive, and statistically significant for the four pollutants except COD.

4.5 The combined environmental effects of FDI in China

Combining the estimation results in tables 1–5, we can calculate
the combined effects of FDI on pollution emissions. Specifically, to
simultaneously solve the system of six equations, we can obtain the
measures of the scale effect, technique effect, composition effect as well as
the total effect of FDI on pollution emissions as follows:
⎧
⎪
⎪ ∂ log poluit
⎪
⎪ Total effect :
⎪
⎪ ∂ log fdi
⎪
⎪
⎪
⎪ (b 3 + c 1 + c 3 d1 ) + (1 + b 5 + c 4 ) (a 1 + a 2 d1 )
⎪
⎪ =
⎪
⎪
⎪
⎪ 1 − (1 + b 5 + c 4 ) a 4
⎪
⎪
⎪
⎪ ∂ log gdp (b 3 + c 1 + c 3 d1 ) a 4 + (a 1 + a 2 d1 )
⎪
⎨Scale effect :
it
=
∂ log fdi 1 − (1 + b 5 + c 4 ) a 4
.
⎪
⎪ ∂ log tech (b 3 + c 1 + c 3 d1 ) a 4 + (a 1 + a 2 d1 )
⎪
⎪ Technique effect :
it
= b3 + b5
⎪
⎪ ∂ log fdi 1 − (1 + b 5 + c 4 ) a 4
⎪
⎪
⎪
⎪ ∂ log compit
⎪
⎪
⎪
⎪ Composition effect :
⎪
⎪ ∂ log fdi
⎪
⎪
⎪
⎪ (c 1 + c 3 d1 ) (1 − a 4 − a 4 b 5 ) + c 4 (a 1 + a 2 d1 ) + b 3 a 4 c 3
⎪
⎩ =
1 − (1 + b 5 + c 4 ) a 4
So the total environmental effect of FDI ∂ log polu/∂ log fdi can be
decomposed in the following way. (1) The coefficients a 1 , b 3 and c 1
measure the direct scale, technique and composition effect of FDI,
respectively. According to the estimation results, while both the scale
and composition effects are positive, the technique effect is negative. (2)
Capital accumulation effect of FDI. Since domestic capital accumulation
is one of the major determinants of both economic growth and industrial
composition, foreign investment may indirectly affect environmental
pollution through increasing investment formation in host countries. Such
an indirect pollution effect of FDI depends on how FDI affects capital
accumulation (d1 ), and how capital accumulation in turn affects economic
growth (a 2 ) and industrial composition (c 3 ). Hence, such an indirect
pollution effect of FDI can be measured by d1 (a 2 + c 3 ). It is estimated that
physical capital stock will increase by 0.06–0.07 per cent with a 1 per cent
increase of FDI. As the estimation results in tables 1 and 4 show that a
higher capital stock will cause both a higher level of economic scale and
a larger share of industrial output, this indirect pollution effect of FDI is
generally positive, implying that foreign investment produces additional
pollution emissions by increasing capital accumulation in China. (3) The
effects of economic growth on the composition and technique effect. While
rapid economic growth consequently causes more pollution emissions, it
also raises people’s demand for a cleaner environment and subsequently
more resources can be spent on pollution abatement as the economy
grows. Our estimation system shows that economic growth tends to
 Environment and Development Economics 87

Table 6. Various effects of FDI on pollution

so2 smoke water solid cod

Total effect ∂polu/∂fdi −0.2473c −0.1414c −0.0234c −0.1296c 0.0581b

(0.0313) (0.0355) (0.0054) (0.0362) (0.0241)
Scale effect ∂gdp/∂fdi 0.1696c 0.1788c 0.1373c 0.1833c 0.1961c
(0.0145) (0.0153) (0.0163) (0.0150) (0.0117)
Technique effect ∂tech/∂fdi −0.4834c −0.3863c −0.2388c −0.3767c −0.2479c
(0.0335) (0.0359) (0.0243) (0.0366) (0.0463)
Composition effect 0.0665c 0.0381b 0.0667c 0.0392b 0.1022c
∂comp/∂fdi (0.0191) (0.0192) (0.0161) (0.0190) (0.0185)

Note: The numbers in parentheses are the estimated standard errors of various
environmental effects, which are estimated applying the usual Delta method.
c
and b indicate the significance at 1 and 5 per cent level, respectively.
Source: Authors’ own calculation.

reduce pollution intensity in industrial output (b 5 ) presumably with

technological progress on the way, and the share of industrial output in
the economy also tends to fall with an increase in economic scale via
the increase in per capita income (c 4 ), reflecting progress in structural
change along the path of industrialisation. These findings are consistent
with the well-known environmental Kuznets inverted-U curve hypothesis
between economic growth and pollution emissions, supporting the notion
that foreign investment may affect host countries’ environmental quality
by boosting their economic growth.6 (4) The feedback effect of pollution
on economic growth. In table 1, pollution emissions have a positive impact
on production scale (a 4 ), and also the scale effect in turn affects both the
composition and technique effects (b 5 + c 4 ). Therefore, the feedback effect
of pollution emissions on economic growth is measured by a 4 (1 + b 5 + c 4 ).
This measure shows that if we do not consider such a feedback effect of
pollution, say a 4 = 0, then the total environmental impact of FDI is just the
sum of the three effects, which may produce biased estimates.
Using the estimated values of various parameters contained in the
estimated system, we can calculate the environmental effects of FDI in
China, which are reported in table 6. The standard errors for various
combined environmental effects of FDI are calculated by using the usual
Delta method (Wooldridge, 2002).
First, the scale effect of FDI is positive for the five pollutants and ranges
between 0.137–0.196, implying that China’s domestic output will increase
by nearly 0.15 per cent with a 1 per cent increase of FDI. While this result is
consistent with the conclusions reached in other studies, the scale effect of
FDI in our study considers not only the direct effect of foreign investment
on economic growth, but also takes into account the indirect scale effect

6
When we estimate such an indirect effect of FDI on both pollution intensity and
industrial composition, it is assumed that FDI does not affect population in host
countries, which seems reasonable. This means that the effect of FDI on logagdp
is equal to that on loggdp.
88 Qun Bao et al.

of FDI, which is measured in two ways. The first is that FDI may indirectly
affect economic growth by promoting physical capital accumulation, which
is a 2 d1 . The second is that FDI may also affect economic growth through
the feedback effect of pollution emission on economic growth, which is
(b 3 + c 1 + c 3 d1 )a 4 . Hence, the combined indirect scale effect of FDI can be
measured as a 2 d1 + (b 3 + c 1 + c 3 d1 )a 4 . This suggests that the role of foreign
firms in China’s regional economic development may be underestimated if
we only consider the direct effect of FDI in the growth accounting analysis.
However, as the entry of foreign firms speeds up China’s economic
growth, it consequently causes more pollution emissions with increasing
production scale, implying that there might be a tradeoff between FDI’s
growth effect and its environmental effect, unless the negative effects of
FDI on pollution through the scale and composition effects are offset by its
technical effect.
Second, the technique effects of FDI are shown to be negative for
all five pollutants, and they range between −0.239 and ∼−0.483. Such
negative technique effects can also be further decomposed into both direct
and indirect effects. The direct technique effect of FDI is the estimated
coefficient b 3 as reported in table 2. The indirect technique effect of FDI is
jointly determined by ∂gdp/∂fdi and b 5 . Take so2 as an example. The direct
technique effect of FDI on so2 is estimated to be −0.381. To calculate the
indirect technique effect of FDI, we need to know not only how economic
development affects the pollution intensity (b 5 ), but also how FDI promotes
economic development, which is measured as the scale effect of FDI.
Therefore, the combined indirect technique effect of FDI can be identified
as [a 1 + a 2 d1 + (b 3 + c 1 + c 3 d1 )a 4 ]b 5 , and a simple calculation shows that
this indirect technique effect of FDI on so2 emission is −0.102. Hence, the
combined technique effect of FDI on industrial sulphur dioxide emission
can be calculated as the sum of the direct and indirect technique effects,
namely −0.102+ (−0.381) = −0.483.
Third, similar to the approach for examining FDI’s technique effect, the
composition effect can also be divided into two: the direct composition
effect measured by c 1 as reported in table 4, and the indirect composition
effect of FDI captured by the extent to which foreign investment may affect
the capital/labour ratio and GDP per capita. While the direct composition
effect of FDI is estimated to be significantly positive (table 4), its indirect
composition effect is generally negative (table 7).
Finally, combining the three effects, we can get the total environmental
effect of FDI in China, and its results are shown in table 6. It can be seen
that as a whole the entry of foreign firms generally helps reduce pollution
emissions except for COD (0.0581). Among all the pollutants, the pollution
reduction effect of FDI is the largest for industrial sulphur dioxide (−0.247),
which is followed by −0.141 for industrial smoke, −0.129 for industrial
solid wastes and −0.023 for industrial polluted water.
A further calculation demonstrates that such a negative combined effect
of FDI on pollution emissions in China can largely be attributed to its
technique effect. For all five pollutants we have studied, both the scale
effect and the composition effect are estimated to be positive, and the
technique effect is calculated to be negative. Therefore, whether the entry of
 Environment and Development Economics 89

Table 7. The decomposition of the three environment effects

so2it smokeit wastit solidit codit

Scale effect 0.1696 0.1788 0.1373 0.1833 0.1961

Direct scale effect 0.1447 0.1808 0.1196 0.1830 0.1468
Indirect scale effect 0.0249 −0.0020 0.0177 0.0003 0.0493
Technique effect −0.4834 −0.3863 −0.2388 −0.3767 −0.2479
Direct technique effect −0.3813 −0.3236 −0.1541 −0.3039 −0.1273
Indirect technique effect −0.1021 −0.0627 −0.0847 −0.0728 −0.1206
Composition effect 0.0665 0.0381 0.0667 0.0392 0.1022
Direct composition effect 0.1399 0.1242 0.0974 0.1246 0.1565
Indirect composition effect −0.0734 −0.0861 −0.0307 −0.0854 −0.0543

Source: Authors’ own calculation based on the estimation results from the
study.

foreign firms in China helps reduce pollution emissions and hence improve
the environmental quality depends essentially on the comparison or the
relative strengths of the three effects, namely whether the technique effect
dominates the combined environmental effect or vice versa. Take industrial
polluted water as an example. Its scale, technique and composition
effect are estimated to be 0.1373, −0.2388 and 0.0667, respectively (see
Appendix 5, available at http://journals.cambridge.org/EDE). Comparing
the three effects, we can find that the scale effect and technique effect
capture most of the pollution effect of FDI. While the composition effect is
estimated to be positive, it is much less important in terms of its magnitude.
As the combined effect of FDI on polluted water emission is −0.0234, such a
negative effect can mainly be attributed to its technique effect, i.e., the entry
of foreign firms helps reduce the pollution emission intensity. Take COD as
another example. As the combined effect of FDI on COD is positive, the
only one among the five pollutants, this is mainly attributed to the fact that
the technique effect of FDI on solid wastes is relatively small (−0.2479). On
the other hand, the positive scale and composition effects of FDI on COD
are both the largest among the five pollutants. Since the negative technique
effect is not sufficient to offset the combined scale and composition effects,
it is found that the entry of FDI causes COD to increase.
A further decomposition of the three environmental effects of FDI also
enhances the understanding of the mechanisms through which FDI affects
pollution emissions in a detailed fashion. The decomposition results in
table 7 suggest that the estimated role of foreign investment in impacting
on pollution would be largely biased if only the direct effect is considered.
The importance of considering both the direct and indirect effects of
FDI justifies the use of the simultaneous equations estimation technique
applied in this study. Take the technique effect of FDI as an example. Table 7
shows that the positive role of FDI would be underestimated to a certain
extent if we only consider the direct technique effect, since the indirect
technique effect accounts for 21.12 per cent for so2it , 16.23 per cent for
smokeit , 35.49 per cent for wastit , 19.32 per cent for solidit and 48.64 per
90 Qun Bao et al.

cent for codit in the combined technique effect, respectively. As a matter of

fact, while the combined environmental effect of FDI on industrial polluted
water is −0.0234, the indirect technique effect has been as large as −0.0847.
It means that once the indirect technique effect is excluded, the combined
environmental effect of FDI would unexpectedly be positive. Take the
composition effect as another example. The direct composition effect of
FDI is estimated to be significantly positive for all five pollutants, implying
that the entry of foreign investors helps improve the share of industrial
output in the whole economy. However, since the indirect composition
effect of FDI is calculated to be negative, the combined composition effect
of FDI is actually much smaller than the direct one. In other words, the
role of foreign firms in changing China’s industrial composition would
be largely exaggerated if such an indirect composition effect has been
removed.

5. Conclusions
This study simultaneously estimates the environmental effect of foreign
investment in China. The main findings of the study are as follows.
First, the estimated results demonstrate that the entry of foreign firms
helps reduce pollution emissions in China in general. Second, the results
reveal the channels through which FDI affects China’s overall and regional
environmental pollution. It is found that while there is a negative technique
effect, the scale effect and composition effect of FDI are both positive. A
further calculation demonstrates that the role of FDI in pollution reduction
can be mainly attributed to its technique effect, while the importance of
the composition effect is much less. That is to say, foreign investment
helps reduce the pollution emission intensity per unit of industrial output.
Third, we have divided the three environmental effects of FDI into both
direct and indirect ones, and our estimation results show that both types of
environmental effects are important. While the total environmental effect
of FDI depends essentially on its technique effect, we demonstrate that the
indirect technique effect of FDI also plays an important role in pollution
control. In other words, if we overlook the indirect technique effect of FDI,
which is generated by raising the capital/labour ratio and speeding up
economic growth, the role of foreign investment in environment protection
will be significantly underestimated.
Our study contributes to the understanding of the environmental
consequences of foreign firms in a large developing economy, with some
important policy implications. First, FDI has no doubt made important
contributions to the general economic development of the recipient
countries, but the recipient countries should at the same time be aware of
both the negative (such as the scale and composition) and positive (such
as the technique) effects on the environment associated with the inflows
of FDI. As the popular pollution haven hypothesis states, multinational
firms may seek lower production costs in developing host countries
by relocating pollution-intensive industries from rich countries to poor
countries, and hence cause the host countries’ environmental quality to
deteriorate. For the host countries, the study reveals that it is important
to encourage foreign investors to bring in more investments, which
 Environment and Development Economics 91

generate more technique effects. This understanding of the environmental

consequences of FDI becomes even more important when developing
countries are facing the environmental challenge in achieving the objectives
of growth and development. Second, in our study of China’s provincial
data, it is found that the entry of foreign firms does not necessarily cause
more pollution emissions and worsen the environmental quality. What
we need to do is to look at the environmental effect of foreign firms
across different regions within one country. While FDI generally helps
reduce the local pollution emissions in China, the real contribution of
foreign firms to local environmental protection may vary significantly
due to the considerable regional variations in FDI inflows. Finally, a key
issue identified in the study is how to comprehensively evaluate the
environmental consequences of FDI in host countries. To do that, more
attention should be paid to the interaction between foreign investment,
environmental pollution and economic growth in a simultaneous system.
This approach will enable the recipient countries to adopt some appropri-
ate economic and environmental policies aimed at maintaining sustainable
growth.

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