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1 research paper seres Chna and the World Economy Research Paper 2007/32 Foregn drect nvestment and regonal nequalty n Chna by Kale We, Shuje Yao and Ayng Lu The Centre acknowledges fnancal support from The Leverhulme Trust under Programme Grant F114/BF

2 The Authors Kale We s from Unversty of Mddlesex Busness School; Shuje Yao s Professor at the School of Contemporary Chnese Studes, Unversty of Nottngham and an Internal Research Fellow n the Leverhulme Centre for Research on Globalsaton and Economc Polcy (GEP); Ayng Lu s from Unversty of Mddlesex Busness School. Acknowledgements The authors are grateful to valuable comments from Conference partcpants n Nottngham Unversty, WIDER n Helsnk and Fudan Unversty. Fnancal support from The Leverhulme Trust under Programme Grant F114/BF s also gratefully acknowledged.

3 Foregn drect nvestment and regonal nequalty n Chna by Kale We, Shuje Yao and Ayng Lu Abstract One downsde effect of rapd economc growth n Chna has been the ever rsng nterregonal nequalty. Foregn drect nvestment (FDI) has been blamed for drvng the Chnese regons apart. It s dffcult to reconcle the postve effect of FDI on economc growth wth ts potental negatve effect on regonal nequalty. Usng the largest panel dataset for the Chnese regons over and employng an augmented Cobb-Douglas producton functon, ths paper proves that FDI has been an mportant factor of economc growth n Chna. It also suggests that t s the uneven dstrbuton of FDI nstead of FDI tself that has caused regonal growth dfferences. JEL classfcaton: O11, O57, F43. Keywords: Foregn drect nvestment, regonal nequalty, Chna. Outlne 1. Introducton 2. Regonal nequaltes n Chna after economc reform 3. Emprcal models and data 4. Estmaton results 5. Concluson

4 Non-Techncal Summary Rapd economc growth n Chna over the last three decades has been accompaned wth an ever rsng nter-regonal nequalty. The Gn Coeffcent measurng Chna's household ncome nequalty ncreased from n 1984 to 0.45 n 2000 and contnued to rse nto the 21 st century. About one-thrd of Chna s total nequalty has been attrbuted to nter-regonal nequalty. Hgh economc growth and rsng dsparty n Chna s regons have attracted serous attenton n the lterature, but relatvely few studes have provded a detaled assessment on FDI and regonal nequalty. Most of these studes clam that FDI leads to more poverty, solaton, a neglect of local capabltes and larger nequalty. However, f FDI were really responsble for rsng regonal nequalty, then the logcal mplcaton would be that Chna has to reduce the nflows of foregn captal n order to contan such an nequalty. Ths would rase a hghly controversal and provocatve polcy ssue because t would be dffcult to reconcle the postve effect of FDI on economc growth and ts potental negatve effect on equalty. As a result, the lnkage between FDI and regonal nequalty requres further research. Many recent studes have provded clear evdence that FDI has contrbuted not only to economc growth but also to technologcal progress n Chna due to the spll over effects of advanced foregn technologes and nternatonal competton. The emprcal data also show two clear trends n the Chnese regonal economes: a rsng dsparty of regonal per capta ncomes and a skew dstrbuton of FDI towards to the eastern coastal provnces. If Chna s dvded nto three large geo-economc regons, East, Central and West, the East has been growng faster than the rest of the country by about percentage ponts per year over the last 15 years although ts ntal ncome was substantally hgher than ts nland counterparts. In terms of FDI dstrbuton, the pcture s far more n favour of the East, whch has accounted for about 86% of the country s total nflows of foregn captal over the last three decades, and the other two regons, especally the West, have taken a tny share. Usng the most comprehensve and up to day data coverng all the Chnese regons over , ths paper conducts both the σ- and β-convergence analyses. The results show that there s no evdence of absolute β-convergence although there s some weak evdence of σ-convergence n the last few years of the data perod. Ths mples that regonal nequalty n Chna has not been reduced. Instead, t has ncreased over tme. Regonal growth dfferences have been caused by nvestments, populaton growth, human captal, exports, transportaton and most mportantly, FDI. FDI s found to have a postve and sgnfcant effect on economc growth at both the natonal and regonal levels. Ths means that FDI can promote economc growth even n the nland provnces although ts effect n the West s weak, possbly due to the very low level of FDI. Based on the emprcal results, t s concluded that FDI should not be blamed for rsng regonal nequalty. It s the uneven dstrbuton of FDI nstead of FDI tself that has been responsble for Chna s regonal growth dfferences. Such a concluson has a totally dfferent polcy mplcaton as to whether Chna should encourage or dscourage FDI to promote economc growth and contan regonal nequalty. Followng our results, we suggest that Chna should encourage more FDI and should try to mprove the spatal dstrbuton of FDI n favour of the nland areas through preferental polces regardng educaton, nfrastructure, taxaton, and the lke, to mprove ther nvestment envronment and absorpton capabltes.

5 1. Introducton Snce economc reform and the open-door polcy n the late 1970s, Chna has acheved mpressve economc growth at an annual rate of 9.6% durng By 2005, Chna became the fourth bggest economy n the world measured n nomnal dollars and the second largest measured n PPP dollars. However, Chna s economc ntegraton wth the world has been accompaned by growng regonal nequalty. Dfferent regons have not enjoyed equally the fruts of economc reform. Statstcs show that the Gn Coeffcent measurng Chna's household ncome nequalty ncreased from n 1984 to 0.45 n 2000 and contnued to rse nto the 21 century. Chna has stepped nto the stage of "absolute dsparty" (Chang, 2002). st Hgh economc growth and rsng dsparty n Chna s regons attract serous attenton. Researchers debate on whether regonal nequalty has ntensfed and on what has contrbuted to the nequalty n post-reform Chna. Many studes suggest that government polces favorng the coastal regon have worsened regonal ncome nequalty, argung for more resources to be allocated to the dsadvantaged areas (Lakshmanan and Hua, 1987; Kueh, 1989; Cannon, 1990; Yang, 1990 and 1991; Kato, 1992; Cha, 1996; Yao, 1999; Yao and Zhang, 2001a and 2001b; Fu, 2004; Chen and Wu, 2005). However, not all studes agree wth the vew that regonal nequalty has wdened n the post-reform perod. They argue nstead that regonal nequalty has actually declned snce the adopton of economc reforms, manly as a result of dffuson, convergence, nterregonal resource transfer and rural ndustralzaton. Hsueh (1994) argues that natonal economc polces tended to redstrbute captal from rch to poor regons n the 1980s, thereby generatng a process of convergence. Gundlach (1997) found absolute convergence n regonal output per worker across Chnese regons n Raser (1998) also found smlar evdence of absolute convergence usng regonal data n Huo (1994) and Chen and Flesher (1996) saw smlar results. Some other studes show two opposte trends of regonal nequalty n Chna at dfferent perods. For example, Lyons (1991) and Tsu (1991) show a slght declne n nequalty durng and an ncrease n nequalty by comparng the early 1980s wth the 1950s. Sachs and Warner (1996) fnd evdence of convergence from 1952 to 1965 and dvergence 1

6 from 1965 to Snce the late 1980s, however, Sachs and Warner observed a wdened ncome gap between coastal and non-coastal regons. Furthermore, they found that ntraregonal dspartes declned durng the reform perod but nter-regon nequalty experenced lttle mprovement. Jan et al. (1996) argue that real ncome convergence of Chnese provnces was a relatvely recent phenomenon, emergng strongly only snce the reform perod began n After 1990, however, regonal ncomes dverged agan. Tsu (1996) shows that nequalty across dfferent provnces n Chna declned n the frst half of the 1980s, but deterorated agan from the second half of the 1980s. The controversal arguments above may be due to the dfferent approaches and data perods. Compared to other emprcal studes of FDI ssues n Chna, relatvely few studes have provded a detaled assessment on FDI and regonal economc nequalty. However, there are some scholars who have attempted to do so. Most of the arguments n earler studes clam that FDI leads to more poverty, solaton, a neglect of local capabltes and larger nequalty (Mazur, 2000). Sun and Cha (1998) examne the effects of FDI on economc growth n the eastern and western regons of Chna by usng panel data across 16 provnces over They found that the effect of FDI on economc growth was stronger n the eastern regon and very weak n the western regon, whch renforced nter-regonal economc nequalty. Bao et al., (2002) nvestgate the effect of geography on regonal economc growth n Chna durng They clam that the coastal regons had spatal and topographc advantages characterzed by possessng more FDI and moblzaton of rural surplus labor plus lower costs of transportaton and communcaton, whch produced the dsparty from coastal to nland regons. Zhang and Zhang (2003) develop an emprcal method for decomposng the contrbutons of two major drvng forces of globalzaton, foregn trade and FDI on regonal nequalty and apply t to Chna n Globalzaton s found to be an mportant factor contrbutng to the wdenng regonal nequalty. More recently, Fu (2004) nvestgates the spllover and mgraton effects of exports and FDI and estmates ther mpact on regonal ncome nequaltes n Chna and fnds that exports and FDI played an mportant role n rasng regonal dspartes. In contrast, some studes brng out opposte evaluatons about FDI. Dollar and Kraay (2002) argue that the current wave of FDI from the 1980s promoted equalty and reduced poverty. Zhang (2001) nvestgates the role of trade and FDI n a cross-country convergence analyss, ndcatng that export and FDI tend to accelerate the convergence process n the Asan newly ndustralzed economes and Japan. 2

7 The controversal emprcal studes on the lnkage between FDI and regonal nequalty requre further research. Yao and We (2007) clam that FDI has played a dual role on economc growth as a mover of producton effcency and a shfter of producton fronter. FDI s hence regarded as a powerful drver of economc growth for Chna to catch up wth the most advanced countres n the world. Consequently, t s expected that the less developed regons of Chna such as the West and Central provnces mght be able to catch up wth ther rch east counterparts wth more FDI. Ths paper estmates quanttatvely the lnkage of FDI nflow and economc nequalty n Chna s regons usng more recent data, and examnes whether and how FDI has contrbuted to the process of convergence or dvergence of ncome across the Chnese regons. In relaton to the per capta ncome gap wthn Chna, a seres of studes have contrbuted to the evoluton of ncome dstrbuton n Chna durng the pre- and post-reform perods. One group of artcles has decomposed the Gn coeffcent of manland Chna n order to explan the causes of ncome nequalty, and has found that rural-urban nequalty and spatal nequalty are the causes of such nequalty (Tsu, 1996; Yao, 1999; Yao and Zhang, 2001a; Gustafsson and L, 2002). Some artcles employ the classcal approach and the concepts of β- and σ-convergence to address the spatal pattern of Chna s economc growth and ncome nequalty (Jan, Sachs and Warner, 1996; Gundlach, 1997; Raser, 1998; Demurger, 2001; Zhang, 2001; Yao and Zhang, 2001b). In ths study, the σ- and β-convergence tests n absolute and condtonal convergence wth respect to per capta real GDP wll be appled. The next secton presents the background nformaton on Chnese regonal nequalty wth FDI dstrbuton. Secton 3 presents the emprcal models and data defnton. Secton 4 nterprets the emprcal results, and secton 5 concludes wth polcy mplcatons. 2. Regonal nequaltes n Chna after economc reform Economc reforms over the past three decades have brought about exctng growth prospects throughout Chna, especally for some provnces n the coastal regon. Durng , real per capta GDP ncreased more than eght-fold, regsterng an average annual growth of 9.41%, whle that of the East, Central and West were 10.17%, 8.5% and 3

8 8.05% respectvely. 1 The hghest growth provnces are concentrated n the eastern coast whch possesses advantages of geography, endowments, and preferental polces, such as the establshment of the Specal Economc Zones (SEZs) and Open Coastal Ctes, as well as other ncentve polces of attractng foregn nvestments. At the same tme, the ndustralzaton polces towards the Central and Western regons were removed. All of these have allowed the coastal regon to grow much faster than the other regons of the country. Consequently, the Chnese economy has experenced unprecedented rapd and steady growth wth ncreasng nter-regonal dsparty, whch partcularly deterorated after the 1990s. The rato of East-Central-West per capta real GDP was 1.71:1.23:1 n 1979, 2.03:1.15:1 n 1992, and rsng to 2.98:1.56:1 n The regonal dsparty n Chna can be attrbuted to many factors such as dfferent natural resources, human captal endowments, nfrastructure and transportaton, geographcal locaton, proxmty to foregn markets and nvestors, economc structures, coast-orented regonal polcy and foregn drect nvestments. Among these factors, uneven dstrbuton of resources and preferental polces gven to the East are wdely regarded as the domnant causes of regonal nequalty n Chna. 1 In ths paper, East means the coastal eastern regon, coverng Bejng, Tanjn, Laonng, Shangha, Jangsu, Zhejang, Fujan, Shandong, Guangdong (Hanan), Guangx and Hebe. Central means the central regon, coverng Shanx, Inner Mongola, Jln, Helongjang, Anhu, Jangx, Henan, Hube and Hunan. West means the western regon, coverng Schuan (Chongqng), Guzhou, Yunnan, Shaanx, Gansu, Qngha, Nngxa, and Xnjang. 4

9 Fgure1 Real per capta GDP n comparson, (yuan) RGDP per capta (yuan) East Central West year Note: Per capta GDP s measured n 1990s prces. Sources: Chna Statstcal Data for 50 Years (NBS, 1999) and Statstcal Yearbook of Chna (NBS, , varous ssues). Fgure 1 shows that the gap of real GDP per capta between the East and the nland regon (the Central and West regons combned) wdened dramatcally from Per capta ncomes between the Central and the West used to be very close but started to dffer gradually n the followng years as well. The nflows of FDI nto Chna started wth a very low level n the 1980s but rose dramatcally after Deng s famous southern tour n Table 1 FDI and GDP n Chna Year FDI ($ bllon) (1) FDI (RMB bllon) (2) GDP (RMB bllon) (3) FDI/GDP (%) (4)

10 Notes: FDI n Column (1) and GDP n column (3) are measured n current prce. Column (2) and (4) are calculated by the authors. Column (1) fgures are converted to those n column (2) by usng perod average exchange rates. Column (4) equates Column (2) dvdes Column (3). Sources: Chna Statstcal Data for 50 Years (NBS, 1999) and Statstcal Yearbook of Chna (NBS, , varous ssues). Before 1978, Chna vrtually closed ts door to foregn nvestments as a result of the Maost deology of self-suffcency. Snce Chna s pursut of the reform and openng-up polcy n 1978, FDI has gradually blossomed (Tso, 1998). FDI nflow nto Chna ncreased sluggshly before 1992 and was manly concentrated n a few coastal ctes. As ndcated n Table 1, FDI n Chna was only $0.92 bllon n 1983 and grew slowly to $4.37 bllon n However, FDI nflows expanded dramatcally to $11 bllon n 1992 and kept rsng to $60.32 bllon n 2005, makng Chna the largest recpent of FDI n the developng countres after 1996 and then the bggest n the world n Meanwhle, Chna s GDP expanded sharply from 0.60 trllon n 1983, to RMB 2.69 trllon n 1992 and to RMB18.31 trllon n The patterns of growth of FDI and GDP suggested a strong correlaton between them. Ths can be further confrmed by the rato of FDI to GDP, as shown n column 5 n Table 1, whch ncreased slghtly from 0.45% n 1983 to 1.07% n 1991, but doubled n 1992 at 2.25% and reached a peak at 6.04% n However, ths rato gradually declned to only 2.7% n

11 Fgure 2 Shares of real GDP by regon, % 80% 60% 40% West Central East 20% 0% Note: real GDP s measured n 1990s prces Source: 1.Comprehensve Statstcal Data and Materals on 50 Years of New Chna, NBS, Chna Statstcal Yearbook, NBS, Fgure 3 Shares of real FDI by regon, % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% West Central East Note: real FDI s actually used FDI measured n 1990s prces Source: 1.Comprehensve Statstcal Data and Materals on 50 years of New Chna, NBS, Chna Statstcal Yearbook, NBS, GDP and FDI are hghly concentrated n the East n the reform perod (Fgures 2 and 3). The East regon accounted for over 52% of Chna s GDP n 1979 and the share ncreased n the followng consecutve 25 years. The West accounted for a small and declnng share of Chna s GDP over the same perod. The dstrbuton of FDI across regons s far more skewed than that of GDP. Over 86% of Chna s FDI nflows were concentrated n the East. The other two regons were responsble for just 14%. 7

12 Several reasons explan ths geographc polarzaton of FDI. Frst of all, the early reform was focused on the eastern provnces. Guangdong, Fujan, 14 coastal ctes, Hanan and Pudong were gradually opened to foregn nvestors n terms of desgnated Specal Economc Zones, Development Zones, Economc and Technology Development Zones. All of them were gven preferental polces to attract foregn captal and promote exports. Snce the md-1980s, the openng up polcy has been extended northward. Only n the early 1990s were nland ctes and border areas encouraged to open up. In the late 1990s, the Chnese government announced a Western Development Programme amng to restore a more balanced regonal development and decded to apply preferental polces to attract more FDI nto the nland areas. The Western Development Programme may have helped the West to accelerate ts economc growth but faled to reduce ts growth and foregn nvestment gaps wth the Eastern regon. In fact, preferental polces have been only one of the advantages that the East regon offered to foregn nvestors. It also has better economc endowments whch gve t comparatve advantages over the Central and West regons: geographc proxmty to nternatonal markets, better transport nfrastructures, and more sklled labor. Furthermore, many coastal provnces have advanced rapdly n economc lberalzaton, have developed a dynamc non-state sector, and have thus provded a more favorable envronment to foregn nvestors. Fnally, as they have recorded hgher economc growth, they also have provded foregn busness wth larger and rapdly expandng markets. 3. Emprcal models and data Wll the West/Central regons of Chna reman poor for the next century? Wll the East stll be the rch regon n the followng decades? Is the degree of economc dsparty between Chna s regons ncreasng or fallng over tme? The concepts of σ-convergence, absolute and condtonal β-convergence are dscussed n ths secton to answer these mportant questons. 3.1 σ-convergence The concept of σ-convergence can be defned as a group of economes are convergng n the sense of σ f the dsperson of ther real per capta GDP levels tends to decrease over tme (Sala--Martn, 1996, p1020). It s used to reflect the statc dspartes n per capta 8

13 ncome. It can be regarded as evdence of σ-convergence between Chna s regons f regonal ncome dsparty declnes over tme. Commonly, t s measured by the coeffcent of varaton (CV) whch s the rato of standard devaton to the mean 2. CV = ( y y) 2 n (1) y where y s real GDP per capta n regon and y s the mean value. Gven a contracton n CV, we can say that the economes n consderaton have experenced σ-convergence wth reduced dfference n ther ncome levels. A hgher value of CV ndcates a more serous ncome dsparty, and vce versa. The CV not only quantfes the ncome nequalty problem but also measures the development of ncome gap between dfferent economes. It has been wdely used n the lterature, such as Lyons (1991), Tsu (1996), Chen and Flesher (1996), Raser (1998), Zheng, Xu and Tang (2000), Xu and Zou (2000), Wu (2002) and Chang (2002). The CV ndex n these studes s calculated by the net materal product, natonal ncome or per capta GDP n nomnal or real value to assess the evoluton of regonal ncome nequalty n the pre- and post-reform perods. Fgure 4 presents the ndces of CV at natonal and regonal levels based on real per capta GDP. The ncome gap n the whole country durng experenced three phases: declnng from to n , expandng to n 1998, and declnng agan to n Ths pattern reflects the process of economc reform and polces adopted durng the past decades. At the begnnng, the whole country benefted from economc reform, achevng mpressve economc development. Some ntally poorer economes took advantage of ther backwardness and performed more rapdly than some ntally rcher ones, leadng to a contracton of ncome gap for the country. In the second stage, the coastal provnces benefted greatly from the preferental polces granted by the central government. For nstance, the Eastern regon was allowed to adopt a market system and to open ts door to foregn nvestors before the rest of the country. Consequently, FDI largely flowed nto the coastal ctes, greatly acceleratng export actvtes and local 2 Yao and Zhang (2001b) measure σ-convergence by the nter-provncal Gn coeffcent and the tme 9

14 development. As a result, ncome dsparty between the Coastal and Inland regons began to deterorate n ths perod. In the three stage, the ncome gap appeared to have declned thanks to the government s Western Development Programme and the Rebuldng Programme of the Northeast Regon (Zheng, Xu and Tang, 2000; Chang, 2002). However, the reducton n the CV n the thrd phase may be too lttle to be statstcally sgnfcant and whether the ncome nequalty among the Chnese regons really declned has to be tested usng a more robust parametrc approach as wll be dscussed later n ths paper. At the regonal level, three macro-geographcal regons (East, Central and West) are found to have dfferent CVs n terms of ther values and trends. The East had the hghest value of CV and the Central the lowest, meanng that ncome gaps were hghest wthn the East and lowest wthn the Central. The trends of CVs have a clear and declnng tendency n all regons, especally n the East. Oscllaton n regonal CVs mples that ntra-regonal nequalty declned, especally among the Eastern provnces. The sluggshness of the natonal CV and the reduced regonal CVs ndcate that nter-regonal nequalty must have rsen. Ths s consstent wth the concluson drawn by Yao and Zhang (2001b) on the formaton of three geo-economc clubs n Chna under economc reforms. Fgure 4 Coeffcent of varaton n Comparson Naton East Central West Note: CV s calculated accordng to equaton 1. Source: 1.Comprehensve Statstcal Data and Materals on 50 years of New Chna, NBS, Chna Statstcal Yearbook, NBS, standard devaton of log (GDP per capta). 10

15 3.2 β-convergence Accordng to Sala--Martn (1996b, p1020), the defnton of absolute β-convergence can be descrbed as we say that there s absolute β-convergence f poor economes tend to grow faster than rch ones. In other words, ths s to test f an ntally lower ncome group has hgher speed of ncome growth, and convergence s a process n whch the poorer economes catch up wth the rcher ones. Ths argument s based on the neoclasscal model, whch predcts that ntally poor countres wll grow faster than ntally rch ones f the only dfference across countres les n ther ntal levels of captal (Solow, 1956; Sala-- Martn, 1996). However, n the real world, economes may dffer n other respects such as technologcal progress, populaton growth, nvestment, nfrastructure and poltcal stablty. If these dfferences are consdered, the neoclasscal models wll predct that the growth of an economy wll be postvely related to the dstance that separates t from ts own steady state. Ths s the concept known n the classcal lterature as condtonal β-convergence (Sala--Martn, 1990, 1996; Yao and Zhang, 2001b). In absolute convergence, ntal ncome level s the only factor of concern and the catchngup process wll take place f the ntally poorer economes have hgher growth than the ntally rcher ones. To examne absolute β-convergence, the smple regresson that was suggested n Baumol (1986) and appled n Chen and Flesher (1996), Jan, Sachs and Warner (1996), Gundlach (1997), Raser (1998), Zhang (2001) and Yao and Zhang (2001b) wll be adopted n ths research, to regress the growth rate of real GDP (RGDP) per capta aganst the begnnng perod s level of RGDP per capta. The regresson functon s specfed as: Ln ( yt ) Ln( y0 ) = α + βln( y0) + ε t (2) e λt and β = (1 ) Where y t, y 0 denote respectvely per capta RGDP of the endng and begnnng perods respectvely n the th economy, t s the tme span. A statstcally sgnfcant and negatve β suggests absolute ncome convergence. It mples that an ntally poorer economy, such as the remote provnces n western Chna, can take advantages of ts backwardness to acheve 11

16 a hgher growth rate so as to catch up wth the ntally rcher provnces such as the east regon. On the contrary, f β 0, the data exhbts no absolute β-convergence. It may even show an absolute β-dvergence snce an economy wth hgher ntal ncome tends to grow faster; then the ntally rcher economes wll become even rcher, whle the ntally poorer economes wll become even poorer n the group. The value of λ s the pace of ncome convergence (or dvergence). As for condtonal convergence, ncome convergence and the catchng-up process can only be ntated gven the presence of addtonal control factors, such as nvestment rato, populaton growth, openness, FDI rato, human captal and nfrastructure, etc. If absolute β- convergence s observed, then condtonal β-convergence s also mpled. In condtonal β- convergence, the above-mentoned growth related factors determne the steady state ncome level of an economy and f an economy s far from ts steady state ncome level, and t wll tend to have a hgher speed of economc growth untl t arrves at ts steady state. However, n the process of condtonal β-convergence, the ntally poorer economes wll have a tendency to move just towards ts own steady state ncome level. Takng nto account the nvestment rato and the effectve populaton growth rate, the estmaton equaton of condtonal convergence can be wrtten as: Ln( y ) Ln( y t 0 ) = (1 e λt (1 e λt α ) Ln( s) (1 e 1 α β ) Ln( y 0 ) λt α + β ) Ln( n + g + δ ) 1 α β (3) whch was derved from: λt * λt Ln y ) Ln( y ) = (1 e ) Ln( y ) (1 e ) Ln( ) (4) ( t 0 y0 and the steady state level of ncome per capta, y *, was defned as: dln( yt ) * = λ [ Ln( y ) Ln( yt )], where λ = ( n + g + δ )(1 α β ) (5) dt where y t denotes real ncome per capta and y 0 the value n the ntal perod, n populaton growth, g a rate of technologcal progress, δ rate of captal deprecaton. α s the captal share n ncome and β s the labour share. s s the nvestment n physcal captal as a share 12

17 n GDP, λ s the rate of convergence. Accordng to Mankw, Romer and Wel (1992), ths augmented Solow growth model specfes that the growth of ncome s a functon of the determnants of the ultmate steady state and the ntal level of ncome 3. Ths model argues that the ncome per capta n an economy wll converge to the economy s own steady-state level, whch s determned by ts own endowments, such as captal accumulaton, populaton growth and deprecaton, etc. The ncome levels between dfferent economes, however, may not necessarly approach to a smlar level over tme. Specfcatons smlar to the above-mentoned model could also be found n Gundlach (1997), Raser (1998) 4, Zhang (2001) and Yao and Zhang (2001a, 2001b). In assessng the growth pattern of Chna, Yao and Zhang (2001b) has ncorporated some addtonal factors, such as the nternatonal trade to GDP rato, transportaton measured by the equvalent length of hghways and regonal dummes n ther estmaton. Snce FDI s consdered to be one of the engnes to economc growth n Chna (Yao and We, 2007), ths research wll apply smlar specfcaton by addng FDI to examne condtonal β-convergence at natonal and regonal levels. Regressons wll be run on both cross-sectonal and pooled bass to estmate the pace of uncondtonal or condtonal β- convergence, whch s the speed at whch dfferent economes return to ther respectve steady state output levels. The estmatons also am at addressng the growth dscplne of these economes, as well as the contrbutons of dfferent factors, such as nvestment rato, populaton growth, openness rato, FDI rato, human captal and transportaton 5, to the growth pace and speed of ncome convergence. The functonal form of the estmaton equaton s specfed as: LnY t LnY λt 0 = Constant + (1 e ) LnY0 + γ1ln( s) + γ 2Ln( n + g + δ ) + γ 3Ln( FDI ) (6) + γ Ln( Export) 4 + γ Ln( HEP) 5 + Ln ( Tran) + ε 3 Mankw, Romer and Wel (1992), p In Raser (1998), the rato of non-state enterprses output to ndustral producton and lght ndustry output to ndustral producton have been nserted nto the estmaton of condtonal convergence to show how the Open Door Polcy, the market lberalzaton and the structural change have contrbuted to the growth and ncome convergence of Manland Chna. 5 Yao and We (2007) fnd that the factors of FDI rato, export rato, human captal and transportaton have been proved to present sgnfcant mpact on the GDP growth n Chna at both natonal and regonal levels. 13

18 Ths specfcaton s derved from the Solow growth model wth a Cobb-Douglas producton functon as the bass. Where y t, y 0 denote respectvely per capta RGDP of the endng and begnnng perods respectvely n the th economy, the nvestment rato s s calculated as the share of nvestment as a proporton of GDP. The populaton growth n s calculated as the annual growth rate of the year-end populaton. We set (g+δ) equal to 0.05 and assume ths value to be the same for all provnces and all years. 6 FDI s defned as the rato of actually used FDI to total nvestment to avod mult-collnearty and double accountng. Export s also defned as the rato of total value of exports to GDP nstead of the absolute value of export to avod the problem of mult-collnearty. HEP, or human captal, can be defned n dfferent ways, the rato of the number of students enrolled n hgher educaton over populaton, the rato of the number of students enrolled n secondary educaton over populaton, the rato of the number of students enrolled n hgher educaton to the number of students enrolled n secondary educaton, or nvestments n educaton, scence, health care and cultural actvtes. Ths paper chooses the rato of the number of students enrolled to hgher educaton over populaton. Data for GDP s gross domestc product. All the varables are calculated n 1990 constant prces. The values of exports and FDI are provded n US dollars n the offcal statstcs. Snce they are measured n US dollars, most economc analysts do not bother to deflate the values n current prces nto values n constant prces (e.g. Lu, et al., 1997; Lu, 2000). It s mportant to conduct an approprate deflaton. One relevant deflator s the US consumer prce ndex. The values of trade and FDI n nomnal dollars are deflated by ths ndex. The deflated values are converted nto equvalent values n RMB by multplyng the value wth the offcal exchange rate n 1990 ($1 = RBM 4.784). Snce all the other varables n the model are measured n RBM, t s useful to change these two varables n RBM as well. Tran, or transportaton, s measured as the equvalent mleages of ralways, hghways and waterways per 1,000 squared klometres. Hghway s the domnant means of transportaton n terms of mleages. The ratos of the lengths of ralways, hghways and waterways are 1.00/16.84/1.90 at the natonal level. The smplest way to measure transportaton s to add the total lengths of these three dfferent means of transportaton (e.g. Lu, et. al., 1997; Flesher and Chen, 1997). However, the tansportaton capacty of one mle of ralway s 6 Yao and Zhang, 2001b, p

19 dfferent from that of one mle of hghway or waterway. As a result, t s necessary to convert ralways and waterways nto equvalent hghways. The converson ratos are derved from the volumes of transport per mle by each of the three means of transportaton. At natonal average, the converson ratos are 4.27/1.00/1.06. In other words, ralways are multpled by 4.27 and waterways by 1.06 to derve ther equvalent lengths of hghways. Ths method of converson may not be perfect as the relatve capacty of dfferent transportaton means may not be the same n dfferent provnces. However, any possble converson errors may be small because hghways account for a predomnant proporton of the total transportaton volume (Yao and We, 2007). Data s based on a panel of 29 provnces and muncpaltes (Tbet s excluded and Chongqng s merged wth Schuan) for the perod Two prncpal data sources are avalable: Chna Statstcal Data 50 Years (NBS, 1999) and Chna Statstcal Yearbook (NBS, varous years, ). The above-mentoned β-convergence test wll be employed to examne whether and at what speed the per capta ncome level of Chna and ts regons are convergng after controllng ther growth potental, or f the ntally poorer nland Chna s able to grow at a hgher speed than the ntally rcher coastal east. To address the ssue of absolute β-convergence among regons, a smple estmaton wll be employed on the growth rate of per capta RGDP at the begnnng year s per capta RGDP. The ntenton s to assess f the growth rate of these economes s negatvely related to ts ntal ncome level. Gven a negatve and statstcally sgnfcant estmated coeffcent for the ntal ncome level, t s possble to conclude that the ntally poorer economy s able to have a hgher growth rate whch enables t to catch up wth the ntally rcher economy, and β-convergence s takng place n an absolute manner. Both cross-secton and panel data approaches are employed n ths secton for comparson. In the panel regresson, the samplng perod ( ) can be dvded nto sx tme spans: , , , , , When t =1983, for example, t-1 =1978, all the related varables to each provnce are the averages over Data for the other perods are derved n the same way. 15

20 4. Estmaton results In the estmatons, the Chnese provnces are dvded nto three regons:east (Coastal), Central and West (see footnote 1). Income convergence wll be analysed for each regon and for the whole country. In addton, a par-wse analyss s also conducted to examne the convergence or dvergence for the followng pars of regons: East-Central, East-West and Central-West. 4.1 Estmaton results of β-convergence at natonal level Absolute ncome convergence Based on equaton (2), only ln(y 0 ) s ncluded on the rght-hand sde to test for absolute convergence. As reported n the upper panel of column 2 n Table 2, there s no evdence of absolute β-convergence. The estmated coeffcent of ntal ncome durng s statstcally nsgnfcant, mplyng that the ntally poorer Chnese provnces do not have hgher growth than the ntally rcher ones and thus fal to catch up. The ntally poorer provnces could be benefted by the reforms to grow faster than before. However, the coastal provnces mght be able to contnuously derve dsproportonately greater benefts from the reforms after 1992 as the central government encouraged them to speed up the pace of reform and development wth more open polces n terms of FDI and exports. Ther speed of growth mght then out-perform the others. Hence, the process of absolute convergence has not been found n the entre post-reform perod. Ths fndng s rather smlar to those offered by Chen and Flesher (1996) and Jan, Sachs and Warner (1996) n whch the former dd not show any absolute β-convergence n both the pre- and postreform perods, whle the latter suggested a mxed result wth no clear absolute β- convergence. Table 2 Basc convergence regressons analyss at natonal level, Method Cross Secton Analyss Panel Data Analyss Constant (28.372)** (32.751)** Ln Y (-0.557) (1.582) Impled λ Adjusted R

21 Wth east dummy Constant (21.853)** (28.296)** Ln Y (-3.258)** (0.239) East dummy (5.032)** (2.969)** Impled λ Adjusted R Notes: Estmated equaton: LnY t LnY λt 0 = Cons tan t + (1 e ) + ε. t statstcs n parenthess. ** and * ndcate statstcal sgnfcance at 1% and 5% level respectvely. Yt and Y0 are real GDP per capta n the th provnce n 2003 and 1979 respectvely n cross secton analyss. In panel data analyss, they are real GDP per capta n each endng year and begnnng year of sx tme spans. Real GDP s calculated at constant 1990 prces. East dummy s that takng the value of 1 for an eastern regon and 0 for otherwse. Source: 1.Comprehensve Statstcal Data and Materals on 50 years of New Chna, NBS, Chna Statstcal Yearbook, NBS, LnY 0 An East dummy s ntroduced n the analyss to capture the mpact of the preferental polces favorng the east regon. As shown n the second panel of column 2 n Table 2, ncome convergence s observed and the adjusted R 2 ncreases sgnfcantly compared wth that n the upper panel. It shows that economc reform and the resultng hgher growth have brought about condtonal β-convergence, partcularly to the eastern regon. The speed of convergence s 1.67% n the cross-secton regresson. Ths may mply that some of the ntally poorer economes n the East, such as Guangdong and Fujan, have experenced a rapd growth after economc reform whch enabled them to catch up wth the other ntally rcher economes n the country. Furthermore, the east dummy s strongly sgnfcant. It shows that the east regon has ts own ncome growth pattern whch s dfferent from the other regons of the country. Ths specfc growth dscplne could very much be explaned by the open door polces and the preferental treatment whch were frstly ntroduced n the coastal regon wth an ntenton to promote trade and to attract foregn nvestment. Apart from the cross-sectonal analyss, the panel data approach has also been advocated to address the ssue of absolute β-convergence. Such pooled analyss may help to resolve the possble sgnfcance problem whch s caused by the shortenng of observatons. As ndcated n the frst half of column 3 n Table 2, lke ts cross-secton counterpart, no evdence of absolute β-convergence can be found. The estmated coeffcent on the ntal ncome level s even postve although t s nsgnfcant. The adjusted R 2 s very small. It means that Chnese provnces were not able to move ther ncome levels towards the natonal mean, and the ntally poorer regons faled to have a hgher growth rate after economc reform. In other words, the West or/and Central regons faled to catch up wth the East. Dssmlar to the cross secton regresson, the ntroducton of an east dummy 17

22 could nether revse nor mprove the estmaton results as the estmated coeffcent of the ntal ncome level s stll nsgnfcant. However, the east dummy s statstcally sgnfcant and rases the adjusted R 2 although t s stll small. Ths fndng ndcates that the ntal ncome level and east dummy are far away from explanng the dependent varable. Table 3 compares our estmated results wth those n the lterature for dfferent data sets. Our cross-secton regresson for the perod , lke the regresson by Yao and Zhang (2001b) for cross-secton analyss as well as Chen and Flesher (1996) for , shows evdence of convergence, but the test statstcs are not sgnfcant. In contrast, lke the cross-secton regresson by Chen and Flesher for a longer tme perod , our panel data regresson shows evdence of dvergence, although t s also nsgnfcant. The panel data regresson by Yao and Zhang (2001b), however, shows a clear evdence of dvergence because the value of λ s negatve and sgnfcant. Ths evdence contrasts sharply wth that presented by Gundlach (1997) and Raser (1998). Accordng to the neo-classcal model, the ntally poor countres wll grow faster than the ntal rch ones f the only dfference across countres les n ther ntal level of captal (Solow, 1956; Swan, 1956). However, n the lterature, many studes fnd no evdence of absolute convergence for countres wth dfferent nsttutons, preferences and producton technologes. Sala-I-Martn (1996) shows sgnfcant dvergence rather than convergence by estmatng the data for 110 countres durng and the speed of dvergence was 0.4% per annum. Ths fndng mples that economes may dffer n other respects n the real world, such as populaton growth, savng behavor, technology and poltcal stablty. If these dfferences are consdered, the neoclasscal model wll predct that the growth of an economy wll be postvely related to the dstance that separates t from ts own steady state. Ths s the concept of condtonal convergence and focus of analyss n the next secton. Table 3 Speed of convergence and dvergence (λ) for dfferent data sets Data set Cross-secton regresson λ t value R 2 Our estmates Chna 29 Provnces ( ) (cross-secton data) Chna 29 Provnces ( ) (panel data) Yao and Zhang (2001b) 18

23 Chna 30 Provnces ( ) (cross-secton data) Chna 30 Provnces ( ) (panel data) Chen and Flesher (1996: Table 1) Chna 25 Provnces ( ) (cross-secton data) Chna 25 Provnces ( ) (cross-secton data) Raser (1998: Table 2) Chna 28 Provnces ( ) (cross-secton data) Gundlach (1997:p426) Chna 29 Provnces ( ) (cross-secton data) Sala-I-Martn (1996) World 110 countres ( ) OECD countres ( ) UAS 48 states ( ) Germany 11 regons ( ) UK 11 regons ( ) Notes: (1) The values n column 3 are asymptotc t-value for the convergence speed parameter λ. If the value λ s postve, t ndcates convergence, or vce versa. (2) Yao and Zhang (2001b) use real GDP per workng-age person nstead of real per capta GDP. Furthermore, they had data for 30 provnces. And ther results are most smlar to ours. (3)Chen and Flesher (1996) use real per capta natonal ncome, nstead of real per capta GDP n and real per capta GDP n At the tme of ther wrtng, GDP data was not avalable before 1988 from offcal statstcs. In addton, they dd not have data for fve provnces, Guangx, Jln, Hanan, Qangha and Tbet. Despte the obvous caveats n the data sets, ther results are not fundamentally dfferent from ours. (4) Raser (1998) takes data from a number of dfferent sources, ncludng hs personal calculatons. Condtonal ncome convergence If the ntally poorer economes cannot grow faster than the ntally rcher ones, then they should have faled to catch up and reduce ther ncome gap wth the ntally rcher economes. Nevertheless, they may stll be able to move ther ncome levels to ther respectve steady states, whch are determned by some growth related factors. Based on ths belef, the condtonal ncome convergence test wll be performed to estmate f the catchng-up and convergence process wll take place after mposng controls on the growth potental of these economes, despte no tendency of absolute ncome convergence. In equaton (3), only two basc factors, nvestment rato and effectve populaton growth rate, plus the ntal ncome are added to the rght hand sde of regresson. As ndcated n Table 4, n the cross-secton estmatons, these two factors appeared to be statstcally nsgnfcant wth wrong sgns and they are able to nether mprove nor revse the results of ts absolute manner n Table 2. There s no evdence of condtonal convergence and the 19

24 estmated coeffcent of the ntal ncome level s nsgnfcantly postve. Furthermore, the adjusted R 2 s stll small, mplyng poor goodness-of-ft n the regresson. In other words, there s no evdence of condtonal ncome convergence between the Chnese provnces and the pace of ncome growth for the perod mght be ndependent of nvestment rato and effectve populaton growth. Ths result matches some of the fndngs n Gundlach (1997), Yao and Zhang (2001a) and Jones, L and Owen (2003). When the east dummy s adopted n the estmatons, the explanatory power of these two addtonal varables s stll poor. But the east dummy s statstcally sgnfcant and has contrbuted to brng about negatve sgnfcance at 5% level on the ntal ncome. In addton, the adjusted R 2 ncreases to 0.433, and the speed of convergence rses to 1.36%. Ths result reveals that the process of condtonal convergence s almost ndependent of the nvestment rato and effectve populaton growth. The results of panel data regressons are presented n the last column of Table 4. In general, the sgnfcance of estmaton results on convergence has obvously mproved compared wth ether ts absolute manner or cross-sectonal counterpart. The two explanatory varables now have rght sgns and the nvestment rato s sgnfcant at 5% level. Besdes, they have contrbuted to change the estmated coeffcent of the ntal ncome to be negatve although t s nsgnfcant. After the east dummy addressng, the estmaton results are strkng. There s strong evdence of condtonal ncome convergence n and all the explanatory varables become strongly sgnfcant n proper sgns. The estmated values of adjusted R 2 and speed of convergence have also mproved. Ths confrms that the regon-specfc effects must be correlated wth the ncluded varables. As explaned above, nvestment rato and effectve populaton growth rate are just two of the factors that may affect growth. A hgh nvestment rato and a low effectve populaton growth rate may be necessary but not suffcent for achevng hgher growth. Therefore, they are not satsfactory explanatory varables and have faled to explan the growth dscplne of the Chnese provnces. Ths suggests that some mportant explanatory varables other than the nvestment rato and populaton growth are mssng from the regressons. Table 4 Condtonal convergence regressons at natonal level, : by addng ln(s) and ln ( n+g+δ) Method Cross secton analyss Panel data analyss 20

25 Constant (0.974) (-2.022)* Ln Y o (0.216) (-0.687) ln(s) (-1.337) 0.072(2.090)* ln ( n+g+δ) (0.596) (-0.325) Impled λ Adjusted R Wth east dummy Constant (0.696) (-2.870)** Ln Y (-2.278)* (-2.989)** ln(s) (-0.708) (3.501)** ln ( n+g+δ) (0.196) (-4.862)** East dummy (4.588)** (4.644)** Impled λ Adjusted R Notes: Estmated equaton: LnY λt = Cons tan t + (1 e ) LnY. t statstcs n 0 + γ 1Ln( s) + γ 2Ln( n + g + δ ) + ε parenthess. ** and * ndcate statstcal sgnfcance at 1% and 5% level respectvely. All the values are measured n 1990 prces. Yt and Y0 are real GDP per capta n th provnce n 2003 and 1979 respectvely n cross secton analyss. In panel data analyss, they are real GDP per capta n each endng year and begnnng year of sx tme spans. Investment rato s equals nvestment/ real GDP, populaton growth rate n s the annual growth rate of the year-end populaton. (g+δ) equal 0.05 all the tme. East dummy takes the value of 1 for an eastern regon and 0 otherwse. t LnY 0 Sources: 1.Comprehensve Statstcal Data and Materals on 50 years of New Chna, NBS, Chna Statstcal Yearbook, NBS, The other estmaton on the ssue of condtonal convergence s based on equaton (6), ncludng FDI rato, export rato, human captal and transportaton apart from the two addtonal varables measured above. As shown n Table 5, condtonal convergence s found n both cross-secton and panel data approaches. The estmaton n the panel data analyss presents much more sgnfcance. All the varables except for human captal and transportaton are statstcally sgnfcant n ther expected sgns. However, n the cross secton analyss, only export rato s observed sgnfcant for the condtonal convergence. However, the speed of convergence as well as the adjusted R 2 has experenced remarkable mprovements. The speed of convergence s as hgh as 6.06% per year and R 2 ncreases to from a neglgble value n the prevous estmatons, mplyng a strong goodness-of-ft n ths regresson. Besdes, nvestment rato and effectve populaton growth rate have the correct sgns. In addton, FDI rato becomes sgnfcant when export rato s gnored from the regresson although there s no evdence of condtonal convergence. Ths mples that the explanatory power of FDI and export wll be dluted somewhat when they are employed together. The estmaton results have not mproved nor revsed when the east dummy s nserted. However, not only the estmaton value but the sgnfcance level of 21