The Effects of Cultural Similarity on Foreign Direct Investment and Productivity of Domestic Firms: Identification from Borders of Chinese Dialect Zones

Does cultural similarity affect destination choices of foreign direct investment (FDI)? To answer this question, I provide a novel identification strategy which explores discontinuous changes in investment from Hong Kong, Macau and Taiwan (HMT) to Mainland China at borders of Chinese dialect zones. Mainland China can be geographically separated into various dialect zones. People who speak the same Chinese dialect share the same cultural origin. Thus common dialect can be used to measure cultural similarity among Chinese people. I find that if a location in Mainland China is culturally similar to HMT (speaks the same Chinese dialect as HMT), this location attracts more investment from HMT. Causal effect of common dialect on HMT investment is identified from discontinuous increase in investment at geographical borders of common dialect zones. Share of HMT firms in regions right inside the common dialect border is 5 to 7 percentage points higher than regions right outside the border. In addition, I also find that the discontinuous increase in investment from HMT at the borders is larger in industries that receive less FDI entry-restriction policies. Using common dialect and common dialect interacted with entry-restriction policy as exogenous variations at the dialect borders, I find that presence of HMT firms generates negative horizontal spillover effect on productivity of domestic firms from the same region and same industry. A 1 percentage point increase in share of HMT firms decreases total factor productivity of domestic firms by around 1.2 to 1.4 percent. Validity of identification assumptions are further tested in several placebo tests. As a result, I do not find discontinuous changes in share of foreign firms from regions other than HMT at the dialect borders. Neither do I find discontinuous changes in degree of economic development and geographical conditions at the border.