1. China’s FDI Net Inflow and Deterioration of Terms of Trade: Paradox and Explanation Li Huizhong Fudan University

2. I. Introduction FDI inflow can influence a country’s terms of trade. China has experienced a sustained growth in FDI inflow since its economic reforms. According to the general principle of the effects of international transfers of income on a country’s terms of trade, there should be an improvement in the terms of trade of the recipient country. However, the decline of China’s general terms of trade has not changed. To find the explanation, this paper points out, we should look at the sectoral structure of China’s FDI inflow rather than the aggregate FDI.

3. II. Review on Key Theories Krugman （ 2005 ） proved that an international transfer of income worsens the donor country’s terms of trade and improves the recipient country’s terms of trade. Most international economists believe it. But Bhagwati (1978 ） found that FDI inflow might worsen the country’s terms of trade. The effect of foreign investments in developing countries depends on the country’s trading mode. Under the export promotion strategy, FDI inflow leads to a biased growth in exports thus may worsen the country’s terms of trade. Zhang Biqiong （ 1999 ） and Li Yanyan （ 2002 ） said, when the donor’s industries with comparative disadvantage are consistent with the recipient’s industries with comparative advantage, while stimulating exports growth, transfers of income may worsen the recipient’s terms of trade. Wang Yueping’s research also concludes that the primary cause of the deterioration of China’s terms of trade is that its export growth largely depends on foreign-invested enterprises and labor-intensive products （ 2002 ）.

4. III. Sectoral Structure and Pattern of China’s FDI As China’s FDI has mainly flowed into three forms of foreign-invested enterprises, we hereby analyze the characteristics of the factor intensity of these enterprises in order to reflect the characteristics of the overall FDI sectoral inflow structure. First, consider the overall industrial structure of China’s FDI inflow(see table 1). This indicates that the manufacturing industry remains as the primary sector of FDI inflow.

5. Table 1 The industrial structure of China’s FDI up to 2007

6. Secondly, consider the industrial structure inside the manufacturing industry. The factor intensity has remained unchanged. The foreign-invested enterprises in labor-intensive industries outweighed those in capital-intensive industries. After 1995, the industrial structure of China’s FDI inflow saw a big change, characterized by an increasing FDI inflow into mechanical and electrical industries. However, it did not change the fact that labor-intensive industries are still the primary terminus of FDI inflows. The processing trade in the foreign-invested enterprises provides clear illustration. (see table 2)

7. Table 2 Statistics of the processing trade of the foreign-invested enterprises in China Unit: billion US Dollars Source ： Statistics of 1996 from World Investment Report 1999, UNCTAD Statistics of 2000\2004 \2006\2008 from China Investment Guide ： http://www.fdi.gov.cn/pub/FDI/wztj/wstztj/default.htm

8. IV. Effects of labor-intensity of China’s FDI on Terms of Trade Excess supply Due to the ‘infinite labor supply’ in China, the per capita capital did not increase but was decreased by the increase in the labor supply caused by labor inflow from outside the manufacturing industry. As a result, the capital inflow in labor-intensive exports sectors did not lead to an increase in capital intensity but in labor-intensive exported products. The excess supply worsened the terms of trade through the competition in the global market. Since East Asia countries, especially South Korea and Japan, have similar exports structure as China. As a result, on one hand, the competition among these three countries has led to a significant change in China-Japan and China-Korea bilateral trade ; on the other hand, the competition in the western markets is another cause which made the decrease in price an inevitable trend.

9. Excess demand The deterioration of terms of trade is in the countries where domestic capital- and technology-intensive industries are underdeveloped and the intermediate products for exports depend on foreign market. This is exactly the situation in China since the 1990s during which FDI has stimulated China’s growth in exports while stimulating its rapid growth in imports as well.

10. Table 3: Imports and Exports of the Foreign Invested Enterprises in China 1990-2008

11. While stimulating exports growth, FDI stimulated the growth of imports of intermediate products even more because the primary investment form of FDI, i.e. the processing trade, is unchanged since China’s economic reforms. This led to the deterioration of the terms of trade through the following two mechanisms: 1. Competition in the global market 2. Price diversion

12. V. Conclusion With substantial foreign investments inflow, the capital- and technology-intensive sectors, facing the import competition, have not enjoyed a satisfying expansion, but suffered from a further contraction. This biased growth among the exports sectors, causing the excess supply and the excess demand for the capital- and technology-intensive products, has aggravated the deterioration of China’s terms of trade.