How does financial system efficiency affect the growth impact of FDI in China?

Purpose - In spite of being the second largest recipient of foreign direct investment (FDI) in the world, China shows limited evidence of considerable FDI benefits on growth (Fan and Hu; Luo; Ranet al.). Motivated by Alfaroet al.'s model, the purpose of this study is to test whether poor financial market development might be responsible for the relatively low benefits of FDI on growth in China. Design/methodology/approach - The author applies Blundell‐Bond system GMM estimators to a panel of Chinese provinces. Findings - The results indicate that poor financial intermediation does indeed limit the transmission of FDI benefits within the Chinese economy. Moreover, the study reveals preliminary evidence that banks' credits to unproductive state‐owned enterprises (SOEs) constitute poor financial intermediation with negative growth implications. In contrast, credits to small private enterprises are associated with a positive impact of FDI on growth. Research limitations/implications - The study is constrained by data availability especially for private credit data across provinces. Practical implications - Two policy implications can be drawn from the empirical findings. First, the direct policy implication is that to ensure positive benefits from FDI in China, domestic financial reforms are crucial. This is an important perspective for making FDI policies. The results also reveal some key priorities of financial reforms. More credits to small private enterprises are an indication of good financial intermediation, while more loans extended to unproductive SOEs signal poor financial intermediation. The priority of reform comes down to tackling the difficult problem of credit misallocation. Originality/value - This paper provides an alternative perspective to address the weak FDI‐growth relationship found in China. Inspired by Alfaroet al.'s model and the understanding of the problem of Chinese financial markets, the study examines the role of the financial system in the FDI‐growth linkage and reveals how financial market conditions could influence FDI benefits in China.