Local financial intermediation and foreign direct investment: Evidence from China

Abstract

We examine the causal relationship between local financial intermediation (LFI) and foreign direct investment (FDI) in China. Using the only data available on LFI from 166 Chinese cities over the period 2003–2009, and addressing endogeneity in the relationship, we find that a 1% improvement in LFI raises FDI in a representative city by 3.77%. Use of city-level data allows us to explore heterogeneity in the relationship across cities. When we do this, we find that the relationship is much stronger in inland cities than in coastal cities. Conceptually, our findings suggest that deeper LFI mitigates the cost of doing business in economically backward inland cities. Methodologically, our findings are robust to different estimators, model specifications, and measures of FDI. From a policy perspective, we show that improving LFI can be a preferred alternative to concessional arrangements for attracting FDI. Our finding suggests a new transmission channel of LFI in economic development across the emerging markets.