Purpose – The purpose of this paper is to examine the relationships between foreign direct
investment (FDI), wages and productivity in China. The direction of causality among these variables
is also to be emphasized.
Design/methodology/approach – The authors develop a system of equations and test the
relationships based on a vector autoregressive regression (VAR) model and two-step generalized
method of moments (GMM)-type estimation approach. They use a panel data set of China’s provinces
for a 20-year time period, 1988-2007, and also distinguish between the coastal and inland provinces.
Findings – The result confirms the cheap labor argument for China, although this particularly true for
inland provinces. In the coastal provinces, FDI inflow influences the wage rates upwards. FDI also has a
positive effect on productivity, particularly in the coastal provinces, but does not act as a significant
determinant of FDI.
Research limitations/implications – Factors other than wage rates and labor productivity are also
important determinants of FDI. This paper focuses on the interplay of these three variables, while
assuming other factors constant.
Practical implications – Cheap labor as an attraction of FDI is a short term policy. Improvements in
productivity should be the focus both in the coastal and the inland provinces. A conducive business
environment, a suitable education policy and incentives for greater R&D contribute toward improving
labor productivity, which in turn attracts greater FDI inflow.
Originality/value – The paper provides empirical evidence on the direction of causality between FDI
inflow, wages rates and labor productivity in one system of equations