The Impact of Input Trade Liberalization on the Entry of Foreign Firms: Evidence from a Quasi-Natural Experiment in China

AbstractThis paper integrates trade policy and foreign direct investment into a unified analytical framework, and investigates the effects of input trade liberalization on the entry of foreign firms. To identify the causal effects, we utilize China’s accession to the WTO in 2001 as a quasi-natural experiment, and perform difference-in-difference estimation. The results show that input trade liberalization significantly increases foreign entry. We also find that input trade liberalization not only promotes the entry of new foreign firms, but also restrains the exit of existing foreign firms, thereby contributing to the net growth of the number of foreign firms. The mechanism tests show that increasing variety as well as quality of intermediate input and reduction in marginal cost are the potential channels through which input trade liberalization promotes foreign entry. This paper further demonstrates that institutional environment strengths the positive effect of input trade liberalization on foreign entry, and the promotive effect of input trade liberalization on foreign entry increases with industry import intensity, additionally, input trade liberalization is also conducive to improving the quality of foreign investment.Keywords: Input trade liberalizationforeign entryWTO accessionmarginal costJEL CLASSIFICATION CODES: F13F23O10View correction statement:Correction AcknowledgementsWe thank the Editor and two anonymous referees for their insightful comments. All the remaining errors are our own.. Authors are in alphabetical order and contribute equally to the paper. This paper mainly relies on the following two disaggregated data sets: tariff data and firm‐level production data. The tariff data of China is downloaded from the WTO website. The firm‐level production data is maintained by the National Bureau of Statistics (NBS) of China, and it is proprietary, and it can be purchased by contacting NBS of China. Publicly available data and programming codes are available upon request by e-mail to the corresponding author.Disclosure statementNo potential conflict of interest was reported by the author(s).Notes1 The number of foreign firms increased from 21,500 in 1998 to 58,000 in 2007, with an average annual growth rate of 12.4%; the actual use of foreign investment increased from $45.46 billion in 1998 to $74.77 billion in 2007, with an average annual growth rate of 6.1%.2 Although Amiti and Javorcik (Citation2008) also examine the determinants of foreign entry, they focus mainly on the role of market and supplier access, while using input tariffs as a control variable. In contrast, the focus of this paper is on the impact of input trade liberalization on the entry of foreign firms, using China’s WTO accession as a quasi-natural experiment. More importantly, this paper not only conducts empirical research in the region-industry dimension, but also further examines the impact of input trade liberalization on the likelihood of Chinese firms to receive foreign investment as well as the foreign share of equity at the firm level, and the latter of which has not been considered in the current literature.3 It should be noted that import tariffs for all products (not just intermediate goods) within the industry are used to measure industrial output tariff, then weighted by the importance of that input in production, which in turn yields industry level input tariff. In other words, the ‘intermediate’ characteristics are portrayed through Input-Output table. Indeed, this is the most commonly used method for measuring industry level input tariff and has been widely used in the literature, e.g. Amiti and Konings (Citation2007), Topalova and Khandelwal (Citation2011), Yu (Citation2015), Liu and Qiu (Citation2016), Defever et al. (Citation2020), among others.4 Similar to Feng, Li, and Swenson (Citation2016), we regard products with BEC codes ‘111’, ‘121’, ‘21’, ‘22’, ‘31’, ‘322’, ‘42’, ‘53’ as intermediate input imports.5 The product-level data is maintained by the National Bureau of Statistics (NBS) of China for the period 2000–2006, which contains information on each product (defined at the 5-digit product level) produced by the firm.6 They are derived from the World Bank Report entitled ‘Doing Business in China 2008’.7 This is mainly because the settlement of legal disputes usually requires a certain amount of time and material costs. The better institutional environment is, the lower the cost paid for it. Therefore, the foreign intermediate suppliers are more willing to cooperate with firms in better institutional environment.8 It is important to note that since the ASIF data does not further classify the capital of non-Hong Kong, Macao and Taiwan (hereafter referred to as non-HMT), we cannot separate the OECD foreign capital from the capital of non-HMT under current data conditions. For this, we approximate foreign investment in non-HMT regions to OECD foreign investment following Du, Harrison, and Jefferson (Citation2011).Additional informationFundingThis project is financially supported by the National Natural Science Foundation of China [72073074 and 72203110], the National Social Science Foundation of China [22AZD054], and the Fok Ying Tung Education Foundation for Young Teachers in Higher Education Program [171075].