Does Foreign Direct Investment Harm the Host Country’s Environment? Evidence from China

As more manufacturing is moved to the developing countries, policy makers become concerned with the environmental consequence. Relatively lenient environmental policies in the developing countries may give them a comparative advantage in pollution intensive goods, and openness to trade and foreign direct investment might harm the host country’s environment. This study examines the relationship between the scale of foreign direct investment and local air pollution in China and suggests that the opposite might be true. Trade and foreign direct investment could have beneficial effect on a developing country’s environment when the multinationals crowd out inefficient local firms, when they change the industry composition, and when they bring more efficient technology into the host country and improve productivity and energy efficiency. We examine the environmental consequence of foreign direct investment using city level data on air pollution, industry composition, foreign direct investment, and other social economic factors. We exploit China’s half land-locked geographic feature and preferable trade policy granted to selected cities as exogenous variations in the cities’ access to foreign investment. We find a negative correlation between foreign direct investment and air pollution, suggesting that the overall effect of foreign direct investment may be beneficial to the environment.