The Role of FDI

China has been running a large trade surplus with the rest of the world, particularly with the USA and EU. This has caused considerable diplomatic tensions and tremendous pressure on the Chinese currency. Existing analytical studies, however, mostly focus on real exchange rate and income as determinants of China’s trade imbalances. Little attention has been given to the role of inflow and outflow of foreign direct investment (FDI). The purpose of this paper is to fill in this gap in the literature by adding FDI to China’s trade balance model. Fitting aggregate annual data from 1979 to 2007 to SURE (Seemingly Unrelated Regression Equations) and later ARDL (Autoregressive Distributed Lags) models, we find that although outflow FDI does not play an important role in determining Chinese trade flows and trade balance, inflow FDI contribute significantly to Chinese exports and thus its trade surplus with the rest of the world. Interestingly, devaluation of the Chinese currency Yuan is found not to affect Chinese trade balance. We also find that both Chinese income and the income of the world play important roles in Chinese trade imbalance. Finally, we find that Chinese trade imbalance is stable.