Does Foreign Direct Investment Lead to Industrial Agglomeration?

This paper studies the effect of foreign direct investment (FDI) on industrial agglomeration. Using the differential effects of FDI deregulation in 2002 in China on different industries, and using the Ellison-Glaeser index as the measure of industrial agglomeration, we find that FDI actually affects agglomeration negatively. This result is somewhat counter-intuitive, as the conventional wisdom tends to think that FDI influx promotes agglomeration. To reconcile our empirical findings and the conventional wisdom, we develop a theory of FDI and agglomeration based on interplay between technology diffusion and pro-competitive effect. Our theory indicates that which force dominates depends on the scale of the economy. When the scale of the economy is small, FDI promotes agglomeration because competition is not fierce (and technology gap is large); otherwise, FDI promotes dispersion. Our evidence also shows that the FDI deregulation also leads to lower markups, sales, and profits of firms, consistenet with the mechanism of the theory. We also show that both FDI and industrial agglomeration increase industrial growth rate, and the dispersion caused by FDI deregulation accounts for 17% loss in industrial growth rate.