Effects of Special Economic Zones on FDI in Emerging Economies: Does Institutional Quality Matter?

Abstract

This study attempts to prove that emerging markets could partially improve institutional quality in a specific area and benefit the local economy despite the rest of the area having poor institutions. Interestingly, we observed that despite the presence of institutions of comparative disadvantage, emerging economies continue to constantly attract significant foreign direct investment. Hence, this study focuses on a type of place-based policy in China that provides a standard favorable institutional environment in a specific area. Using data from China’s Annual Survey of Industrial Firms and combining official lists of Chinese special economic zones (SEZs), we obtained a dataset of 2660 SEZs from 1998 to 2018, and a sample of 37,251 from 1998 to 2013. Then, we empirically examined the impact and mechanism of SEZs on foreign investment by using time-varying difference-in-difference specification. After a sequence of validity and robustness checks, we found that the establishment of SEZs significantly enhances foreign entry. We also found that partial institutional quality improvement of SEZs is a key mechanism in the location of foreign investment. We conclude that it is beneficial for the government to impose place-based policies such as SEZs that improve partial institutional quality efficiently and promote the local economy.