The Effect of Foreign Entry Regulation on Downstream Productivity: Microeconomic Evidence from China*

• Author: Puyang Sun,Sai Ding,Wei Jiang
• Date: 01 July 2019
• DOI: http://doi.org/10.1111/sjoe.12306
• Published date: 01 July 2019

Scand. J. of Economics 121(3), 925–959, 2019

DOI: 10.1111/sjoe.12306

The Effect of Foreign Entry Regulation on

Downstream Productivity: Microeconomic

Evidence from China*

Sai Ding

University of Glasgow, Glasgow G12 8QQ, UK

sai.ding@glasgow.ac.uk

Puyang Sun

Nankai University,Tianjin 300071, China

puyangsun@nankai.edu.cn

Wei Jiang†

Southwestern University of Finance and Economics, Sichuan 611130, China

jiangwei@swufe.edu.cn

Abstract

We examinethe cross-industr y influence of foreign entry regulation (based on a novelmeasure)

on the productivity outcomes of downstream firms through input–output linkages in China. In

contrast to the significant liberalization of the manufacturing sector, restrictions on the service

sector remained stringent over the period 1997–2007. We find a powerful depressant effect of

foreign entry barriers imposed on the upstream manufacturing and service industries on the

productivity of downstream manufacturers, and this effectdepends on a number of industr y- and

firm-specific features. Our research calls for further investment liberalization (particularly in the

service sector) in China.

Keywords: Competition; foreign entry barrier; input–output linkages; investment liberalization

JEL classification:D24; F14; L5; O12

I. Introduction

Despite some recent efforts to ease curbs on foreign investment, China has

imposed tight regulations on foreign entry since the 1990s. For instance, the

Catalogue for the Guidance of Foreign Investment (hereafter the Catalogue)

published by China’s National Development and Reform Commission is

*The authors are grateful for constructive comments from Daniel Yi Xu, MiaojieYu, Zhihong

Yu, JohannesVan Biesebroeck, Loren Brandt, Albert Park, Cheryl Long, Heiwai Tang, and the

participants at the China Workshop at KU Leuven in July 2015 and the Asian Development

Bank conference at the University of Hong Kong in June 2016.W. Jiang would like to thank the

National Science Foundation of China (grant number 71703129) for financial support.

†Corresponding author.

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926 The effect of foreign entry regulation on downstream productivity

viewed as a central policy of the Chinese government, which asserts that

foreign investment must be made in a manner that is consistent with

China’s economic policy in order to promote its economic development.

Some recent media reports indicate that the Chinese government is

increasingly under pressure to reduce restrictions on foreign investment

in order to lessen the exposure to reciprocal investment barriers. More

importantly, by generating entry barriers and impeding competition and

technological spillover among upstream industries, these regulations might

have significant depressant effects on the productivity of other Chinese

industries through input–output linkages.

In contrast to the large body of empirical research on the impact of

trade liberalization in China, little is known about the effects of investment

liberalization, which allows greater foreign entry in both the service and

manufacturing sectors. With this paper, we aim to fill this significant

gap. The novelty of our paper lies mainly in the following four aspects.

First, unlike much of the literature which examines the direct effect

of regulation on the performance of regulated sectors, we consider the

indirect impacts of foreign entry regulation on downstream manufacturing

activities in China. Modern economies involve very sophisticated input–

output structures. According to Acemoglu et al. (2006), sectoral linkages can

act as important channels through which microeconomic shocks generate

a “cascade effect” – that is, in the presence of intersectoral dependence

in the production structure, idiosyncratic shocks can propagate throughout

the economy and affect the output of other sectors, generating sizable

aggregate effects. Using French firm-level data, Di Giovanni et al. (2014)

show that the inter-firm linkages are approximately three times as important

as the direct effect of firm shocks in driving aggregate fluctuations. Jones

(2013) pinpoints the implications of the input–output structure of the

economy for economic growth and development (i.e., the effects of resource

misallocation can be amplified in the presence of input–output linkages).

This is particularly relevant for China, being the world’s largest and most

dynamic developing country where firms and industries are embedded in a

complex production network. Thus, regulations that hinder foreign access

to domestic markets and unnecessarily constrain competition can be a

drag on the productivity of not only firms and industries that are directly

concerned, but also of other firms and industries which use intermediate

inputs from the regulated industries, thereby generating sizable aggregate

effects. This important cross-industry influence of foreign entry regulation

on productivity outcomes in China has, to the best of our knowledge, been

largely ignored in previous literature.

Second, we construct a novel measure of foreign entry regulation in

China, which consists of more than 900 four-digit industries in both the

service and manufacturing sectors over the period 1997–2007. The original

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S. Ding, P. Sun, and W. Jiang 927

data is from the official Catalogue, which provides explicit information on

the Chinese government’s attitudes to foreign investment. One challenge

is that the listed sectors and product categories in the Catalogue are

not aligned with any formal sectoral or industrial classification system.

We use a unique matching approach to link the information on foreign

entry regulation from the Catalogue with China’s Input–Output Tables

and the firm-level production data of more than 480,000 manufacturing

firms. This novel and comprehensive dataset is superior to the commonly

used OECD indicators of anti-competitive regulations on the product

market, which cover a small number of broadly defined non-manufacturing

industries (Bas and Causa, 2013; Bourl`es et al., 2013; Cette et al.,

2017).

Third, we investigate the trickle-down effects of foreign entry regulation

imposed on both the service and manufacturing sectors on the productivity

performance of downstream manufacturing sectors in China. This is because

downstream spillovers arising from policy reform and foreign participation

in the service sectors are qualitatively different from those arising from

foreign direct investment (FDI) in manufacturing industries (Arnold et al.,

2016). Despite the important role of services (e.g., finance, transport, and

telecommunications) as intermediate inputs in manufacturing, there has

not been much empirical analysis of the effects of services regulation or

liberalization in China. This paper thus provides a more rigorous evidence-

based analysis of the role of foreign entry regulation on the service sector,

as well as on the manufacturing sector, in driving the productivity outcome

of downstream manufacturing industries which rely on intermediate inputs

from the regulated sectors.

Finally, in addition to the overall downstream effects of foreign entry

regulation, the focus of this paper is on various economic mechanisms that

characterize the channels through which upstream regulation on foreign

entry affects the performance of firms in downstream industries in China.

In particular, we assess to what extent the productivity effects of foreign

entry regulation work through some industry-specific channels, such as

the distance to the world technology frontier, the technology-sharing and

labor-structure similarities between upstream and downstream industries,

and some firm-specific channels such as R&D investment and outsourcing

intensity. To the best of our knowledge, none of the existing studies explore

this important research question in such an in-depth and comprehensive

way.

We find that the overall level of foreign entry barriers in China declined

slightly over the period 1997–2007. Despite vast heterogeneity among

different industries, a clear pattern is evident: there has been a significant

move to liberalization in the manufacturing sector, whereas the strict

restrictions on the service sector remain intact. Regression results show

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