iBusiness, 2013, 5, 175-181
http://dx.doi.org/10.4236/ib.2013.53B037 Published Online September 2013 (http://www.scirp.org/journal/ib)
175
FDI in Services and Manufacturing Efficiencies in Host
Countrie s: Evidence from China*
Libin Luo
Beijing international Studies University.
Received 2013
ABSTRACT
The paper studies the correlations between FDI in services and manufacturing efficiencies in host countries. First a
theoretical analysis is presented on the direct and indirect channels through which FDI in services enhances manufac-
turing efficiencies in host countries. Then the forward linkages and backward linkages between FDI in services and
manufacturing sector in host countries are tested empirically using China’s industrial panel data. We find that FDI in
services has positive forward and backward linkage effects on China’s manufacturing sector, with forward linkages
stronger than backward linkages, and the wholesale, retail, trade and restaurant sector has the strongest linkage effects.
Keywords: FDI i n S ervic es; Manufacturing Efficiencies in Host Countries; Inter-industry Technical Spillover
1. Introduction and Literature Review
This paper focuses on the correlations between FDI in
services and efficiencies of manufacturing sectors in
China. The issue is introduced mainly based on the fol-
lowing thr ee phenomena:
First, FDI in service sectors has been growing rapidly
during the past few decades. Since 1990s, FDI in service
sectors began to cover an increasing proportion of the
total FDI, replacing manufacturing and became the most
important sectors utilizing FDI. From 1990 to 2007, the
share of global FDI stock in services was up from
48.61% to 63.84%. China witnessed the same trend in
recent years. From 1997 to 2008, real FDI utilization in
service sectors expanded by 214%; Its pr oportion in total
FDI increased from 26.65% to 41.07%.
Second, China’s manufacturing sector needs to im-
prove its output efficiencies to stay competitive. Great
changes occurred to China’s manufacturing sectors de-
velopment environment. First of all, labor costs keep
climbing up. From 2003 to 2008, average annual wages
of Chinese manufacturing workers almost doubled,
making it one of the fastest growing in the world. With
the growth in Chinese economy and Chinese national
income, labor costs will continue to increase. Second,
natural resource constraint is intensified. Energy con-
sumption has been higher than the production capacity.
From 2001 to 2008, the gap between production and
consumption increased from 57.54 million to 250 million
tons of standard coal. In 2006, GDP per kilogram of oil
in China is 3.2 dollars, below the world average of $5.2.
Third, the appreciation of RMB will dampen the compe-
tiveness of Chinese goods in international market. Chi-
na's manufacturing industry can no longer rely solely on
cheap l ab o r and int ensi ve ene r g y i nput , p r o duc ti vit y mu st
be improved.
Third, service sector is an important source of manu-
facturing efficiency enhancement. Some producer service
inputs, such as research and development, management
consulting, mergers and acquisitions, legal services, are
just like fixed assets in that their cost and revenues need
to be shared for a long time, and they can improve pro-
ductive technology and managerial skills of manufactur-
ing enterprises; other producer services like product de-
signing and marketing and other producer services and
create product differentiation, giving enterprises their
competitive advantages. In addition, producer services
also help to achieve internal and external economies of
scale. In recent years, more and more manufacturing
companies contract producer services out, resulting in
rapid growth of service outsourcing. Outsourcing brings
cost savings and higher qualities. Through outsourcing,
manufacturing companies can enhance their core compe-
titiveness, respond to demand uncertainty. Service out-
sourcing brings better division of labor, striking up the
importance of service sector for manufacturing efficien-
cies.
The importance of producer services and development
*
This work is supported by a grant from visiting scholar program of
Beij ing Municipa l Commis si on of Educat ion (No. 11530500015 ).

FDI in Services and Manufacturing Efficiencies in Host Countries: Evidence from China
176
of service outsourcing have resulted in manufacturing
sectors greater dependence on service input. Dependence
rate of manufacturing sectors on service input in 9 OECD
countries has been rising from 16% in 1970s to 27% in
early 21 century (S. Li, C. Gao, 2008). While the calcu-
lation based on input-output table of China, China's
manufacturing industry's dependence on the service in-
dustr y in d ecli ne, but i n the lo ng run, as Chi na's e conom-
ic growth, China's dependence on manufacturing to the
service sector will gradually increase.
Most parts of FDI in services provide producer servic-
es. For example, in 2007, 86.14% of world total stock of
FDI in services was in areas like finance, trade, business
services, transport, storage and communications sector.
From 2004 to 2008, 75.8% of the service FDI utilized by
China are in real estate, renting and business services,
financial services and the postal industry, transportation,
storage. On the one hand, FDI in producer service sectors
can directly affect manufacturing efficiencies in the host
country; on the other hand, FDI can promote host coun-
try's service industry, thus indirectly affecting the manu-
facturing efficiencies in the host co unt ry.
Theoretical studies on the correlations between ser-
vices sector liberalization and efficiencies of manufac-
turing industry first appeared in 1980s. Markusen (1989)
introduces producer services into the DS production
function as intermediate inputs, finding that producer
services liberalization can lead to large gains. Markusen
et.al. (1990) established a model of producer services,
further analyzing the economic benefits of services libe-
ralization to the host country. Francois (1990) finds pro-
ducer services t obtained by foreign trade or multination-
al corporations promote specialization in developing
countries, playing important roles in achieving domestic
economies of scale.
Compared with the theoretical research, very little em-
pirical research in related fields can be found in the lite-
rature. The earliest empirical literature is Jensen et.al.
(2004), which studies the case of Russia's accession to
the World Trade Organization, finding that elimination
of barriers to FDI in business services enhances factor
producti vit y in s ec to rs tha t us e b usiness se r vi ce as i np ut s.
With Czech enterprise data from 1998 to 2003, Arnold et
al. (20 06) finds that the overa ll liberalization of services,
the presence of foreign service providers, and privatiza-
tion of services all have a significant positive correla-
tionwith the efficiency of the domestic downstream in-
dustries, and liberalization of foreign investment in the
service industry is the most substantial contributor
among the three. Fernandes, Ana M. and Paunov, Caro-
line (2008) employ Chile enterprise data between 1992-
2004 and finds substantial positive correlations between
FDI in services and labor productivities of downstream
manufacturing sectors. Jiang Xiaojuan (2008) finds the
presence of foreign designing enterprises promotes man-
ufac t uring ente rpr ises co mpetitiveness.
Considering the fast growth of FDI in services and
importance of manufacturing sector in China, we need
further research on the mechanisms and relationship be-
tween FDI in service sector and manufacturing efficien-
cies in host countries, to help fully understand the role
and significance of services FDI, and to help explore
effective channels to expedite the transformation and
upgrading of C hina's manufacturing indus try.
The rest of thi s pap er is organized as follows: Part two
analyzes the direct and indirect effects of FDI in services
on manufacturing efficiencies in host countries. Part
three tests the correlations between FDI in services and
manufacturing efficiencies in China with China's indus-
try panel data, with focus on the forward and backward
linkage effects. Part four is conclusions.
2. Influence of FDI in Services on
Manufacturing Efficiencies
FDI in services influence manufacturing efficiencies in
host countries through two channels. In the direct chan-
nel, the output of foreign service enterprises is direct
input into manufacturing sectors in host countries; while
in the indirect channel, the presence of FDI in service
local service sector, which in turn benefit manufacturing
efficiencies.
2.1. Direct Channels
1. Forward-linkage technology spillover. Since most
FDI in services exist in the producer service sectors, they
provide producer services to related manufacturing in-
dustries. Compared with local service enterprises, TNCs
with better technologies and human resources (Fernandez,
2001; Griffith et.al., 2004; Lombard, 1990; Karparty and
Poldahl, 2006) may provide better services, which can
better help improve efficiencies of manufacturing enter-
prises in host countries. Amiti and Konings (2005) find
substantial positive correlation between liberalization of
trade in intermediate inputs and downstream manufac-
turing productivities. Some case studies (Arnold et al,
2006; Fermandes and Caroline, 2008) also find substan-
tial positi ve correlations between FDI in services and the
growth of manu fact uring l abo r pr oductivities.
2. Backward-linkage technology spillovers. Take
wholesaling and retailing industry as an example. Gereffi
(1994) categorizes global production chains into two
types, producer-driven and buyer-driven. The latter is
driven by large retailers, which engage in designing and
marketing, and outsource production process to manu-
facturing suppliers. Large multinational retailers often
require their suppliers to reduce costs and improve qual-
ity. Moreover, because multinational retailers usually

FDI in Services and Manufacturing Efficiencies in Host Countries: Evidence from China
177
have better distribution efficiencies, suppliers in manu-
facturing sectors compete to enter, which gives manu-
facturers incentives of improving quality and reducing
costs.
3. St rengt hened te chnology spillover effect. Compared
to FDI in manufacturing sectors, FDI in services have
stronger technology spillover effects, because the spil-
lover effect FDI in services has on manufacturing indus-
tries is inter-industry, while in manufacturing FDI cases,
there could be either inter-industry or intra-industry.
Theoretical and empirical finds that inter-industry tech-
nology spillover is e asier to occur1.
Soft technology transfers brought by manufacturing
multinationals are mainly organization-wide, therefore
the producer services that produce soft technologies will
only support the manufacturing process for local
branches of multinationals, instead of being transferred
by trade or licensing (Markusen, 1995). Local manufac-
turing enterprises can onl y obtain soft technologies fro m
manufacturing TNCs through non-market activities such
as cooperative effect, competition effect and demonstra-
tion effect and so on.
FDI in service sectors, especially FDI in producer ser-
vices are the manifestation of producer service
``externalization'' in globalized world, which expand
specialization and division of labor to host countries.
Market-seeking FDI in the services target local enter-
prises in host co untries as clients fro m the very beginning ;
those who fo llo w their exi sti ng cl ients into host cou ntries
will finally extend their client base to local manufactur-
ing companies. For example, at present, over 70% of
revenues of the majority of foreign management con-
sulti ng fi rms i n Chi na c ome fr om local custo mers. In this
sense, services FDI has stronger technology spillover
effects on local manufacturing enterprises in host coun-
tries.
4. FDI in services has interactions with that in manu-
facturing sectors. First of all, some FDI in services are
from manufacturing multinational companies, providing
support to their business in host countries, especially in
trade and finance. Second, client-following FDI can en-
hance operational efficiencies of foreign manufacturing
companies in host countries. Moreover, the existence of
services FDI provide sound infrastructure for manufac-
turing companies; and with overseas business matures,
service MNCs also encourage their customers in home
countries to expand their business in host countries (Da-
niel, 1993). Case studies on Japan finds in late 1980s and
early 1990s, the presence of Japanese MNCs in service
sectors brought new Japanese multinationals in manu-
facturing sectors. The study proposes two reasons: tech-
nological advances make services a more important input
in manufacturing sectors; relative to large-scale manu-
facturing enterprises, smaller manufacturing enterprises
rely more o n existing service provider networks, and the
presence of Japanese service multinationals reduced
overseas investment cost. Chyau T uan and Linda FY Ng
(2003) make a case study on Guangdong Province in
China , which finds substan tial corre lations between loca-
tion choices of manufacturing and service FDI, especial-
ly between small and medium foreign manufacturing
enterprises and FDI in services, and its large-scale ser-
vice enterprises with FDI location choice of the highest
correlation.
5. Helping upgrade the structure of exportation. Since
many services are not internationally tradable, it is gen-
erally believed that FDI in services has minor influences
on the exports of the host country. (UNCTAD, 2006).
However, many producer services can provide critical
input to manufacturing sectors in host countries, thus
changing the comparative advantages of manufactured
goods and improving their export competitiveness (Mar-
kusen et. Al., 2005). Francois and Woerz (2007) find that
services make the largest contributions to exportation of
goods. Producer service liberalization is significantly
positively correlated with exportation competitiveness of
service- and technology-intensive products, but has a
significant negative correlation with exportation perfor-
mance of non-service-intensive products. Wolfmayr.Y.
(2008) tests the correlations between service linkage and
market share of the exported manufactured goods, and
finds international service linkage has the significant
positive effects on high-tech. products exportation.
2.2. Indirect Channels
1. Encouraging local service providers to improve ser-
vice quality. Blind and Jungmittag (2004) found that FDI
and imports of services have significant positive effects
on the service product and process innovation. Some case
studies also proved the effect of international service on
local service innovation. For example, during the priva-
tization of communications industries in Argentina in
1980s, the introduction of foreign equity participation
have a very big effect on the improvement of communi-
cation infrastructure and the quantity and quality of ser-
vices. Within two years of the reform, the two major
communications companies, Telefonica and Telecom,
increased 330,000 and 270,000 lines respectively, while
in the five years prior to the reform, Telecom, originally
known as ENTel only increased 98,000 lines; In addition,
the companies also update their technologies to digital
systems (Bernard Hoe kman et a l., 1997).
2. Bringing more service varieties. Services are more
1For a literature review about inter-industry and intra-industry tech-
nology spillover, see Jing Peng, Co-
development of MNCs and Local
Enterprises: From
Backward Linkage to Horizontal Linkage. CASS
Dissertation, 2 00 5.

FDI in Services and Manufacturing Efficiencies in Host Countries: Evidence from China
178
differentiated than manufactured goods. Therefore, ser-
vices by multinational providers are more of comple-
mentary than substitution with local service providers.
Case study about FDI liberalization in services in Russia
find s tha t , FDI in services brings a net increase of service
varieties, though competition forced some local service
providers to exit the market2. Other case studies about
Turky, Hungary, Mexico, and Chili also provide such
evidences (Denizer, 1999; McBride, 2004; Cardenas et
al., 2003; ECLAC, 2000). More service varieties help
generate Dixit-Stiglitz-Either effect, raising the down-
stream manufacturing enterprises total factor productivity
(Dixit, A. and J . Stiglitz, 1977; Either, WJ , 19 82).
3. Pushing the service price down. The reasons are
twofold. First, FDI intensifies competition, forcing ser-
vice companies to reduce costs. Sometimes the presence
of multinational corporations breaks the monopoly mar-
ket structure. T he original monopol y is no longer able to
obtain monopoly rents (Fernandes, Ana M.and Paunov,
Caroline, 2008) Classen et.al. (2001) finds that between
1988 and1995, introductions of foreign banks intensified
the competition in the local banking sector, and profit
rates were lowered. Second, for the transnational service
corporations, expanding into foreign markets help them
achieve economies of scale, resulting in possible lower
costs. Service production is differentiated and enjoys
increasing marginal returns, which rely on bigger market
to achieve scale economies (Markusen, 1989). Case stu-
dies about Chili, Mexico and Australia provide some
evidences3.
4. Posing a demonstration effect. FDI in services
brings multinatio nal service corporations, who, with bet-
ter service output and more experienced management,
are a very good opportunity for local firm to learn. The
demonstration effects of service MNCs is easier to occur
than that of manufacturing MNCs, because most service
production and consumption cannot be separated, making
it difficult to keep for technical secret. (Jiang Xiaojuan,
2004).
5. Being the key channel of cross-border technology
spillover in service area. Since service consumption and
production cannot be separated, the soft technology in
services can only be transferred internationally through
FDI. Moreover, human resources is the main carrier of
the soft technology, and multinational corporations pro-
vide the best organizational and institutional arrange-
ments for cross-border mobility of human resources. In
some service areas (e.g. advertising and management
consulting), technologies are ``embedded'' in the com-
plex relation ships and co mmunications within the organ-
izations, which is very hard to be copied by other com-
panies. But it becomes much easier when it is between
headquarters and local branches of one multinational
company. Finally, value chain in the production of most
services can hardly be decomposed, therefore the tech-
nology gap between multinational headquarter and
branches in host countries is much smaller than that in
manufacturing industries, making it easier for host coun-
try to obtain the service technologies(Jiang Xiaojuan,
2004). Grosse (1996) finds that only a very small part of
the service firms transfer technologies through channels
other than FDI.
3. Model
The regr essio n equat ion is the foll owing:
Regression 1:
ititit
ititit
SizeCap
ForlinkBacklinkPro
εαα
ααα
+++
++
lnln
lnln=ln
43
210
Where
it
Pro
is the labor productivity of manufacturing
industry i at the year t, which is calculated as value added
divided by number of working staff. it
Cap
is the capital
per person, calculated as physical capital formation di-
vided by number of working staff.
Sizeit
is the avera ge
size of firms in the manufacturing industry i at year t,
calculated as total number of working staff divided by
number of firms in the industry. it Cap and it Size are
control variables, representing technological levels and
economies of scale.
it
Forlink
and it Backlink are the key variables we
are examining, respectively referring to forward-linkage
and backward linkages between manufacturing industry
and FDI in services. When constructing the two variables,
the basic idea is as follows: first obtain ``the service in-
put in manufacturing industries'' and ``manufacturing
output that is put into the service sectors'', then catch the
part of two values that is related to foreign service firms
with some structural variables.. Since the dependant va-
riable is labor productivity, it Forlink and it Backlink
should also be per capita value, therefore number of la-
bors is used to calculate the average value.
Therefore, the two variables are constructed as fol-
lows.
=
=
t it
it t it
t it
it t it
SerFDI SerInput
Forlink SerInv Labor
SerFDI InputSer
Backlink SerInv Labor
×
×
where
it
Forlink
measures service input per person in
manufacturing industry i in year t that is provided by
foreign service providers; t
t
SerFDI
SerInv is the percentage of
2
See Jesper Jense, Thomas Rutherford and David Tarr, The Impact of
Liberalizing Barriers to Foreign Direct Investment in Services: The
Case of Russian Acces s ion to the World Trade Organization.
3See Bernar d Hoekman et.al.(1997)

FDI in Services and Manufacturing Efficiencies in Host Countries: Evidence from China
179
service FDI in total investment in service sectors, which
give the importance of foreign firms in the service sector.
it
it
SerInput
Labor is service input per person into industry
i at year t.
it
Backlink
measures the per-person average manu-
facturing output that is put into foreign service firms;
it
it
InputSer
Labor
is the output per person of industry i in year t
that is put into the service sect ors.
Two points need to be mentioned here. First, for
structural variable, it is better to use the percentage of
output of foreign service firms in total service output.
However, due to data availability problem, percentage of
investment is used instead. Second, the variable con-
struction can also be used to reflect the backward and
forward linkage between manufacturing industries and
FDI in some particular service industries. Therefore, we
can have regression 2 as follows:
Regre ssion 2:
01 2
34 5
6 78
9
ln= lnln
ln lnln
lnln ln
(1)
itit it
itit it
it itit
it
Protran btran
rnd brandsale
bsale CapSize
AR
αα α
αα α
α αα
αε
++
++ +
+ ++
++
where ,
it
trand
it
rnd
and it
sale measure forward- lin-
kage effect between manufacturing industry i and FDI in
transportation, R&D and retailing & wholesaling indus-
tries; and the backward linkage are measured by it btran ,
it
brnd and it bsale , respectively.
Transportation, R&D and retailing & wholesaling in-
dustries are chosen as typical producer services for two
reasons. First, they are more of producer service nature;
second, better data are available for them.
Data
A panel data of 15 industries with time series from year
2001 to 2008 is used. The Industry classification is based
on input-output table in China. The industry classifica-
tions i n ``C hina S tatist ical Ye arb ook'' a nd ``C hina I ndus-
trial Economy Statistical Yearbook'' are adjusted and
combined to match the input-output tables cla ssification.
Data sources include China Statistics Yearbook, China
Industrial Statistics Yearbook, Input- Output Table of
China(2002, 2005, 2007). All the data has been adjusted
to be comparable. Because input-output data are availa-
ble for only limited years, input-output data for 2002 are
used to represent year 2001-2003; data for 2005
represent year 2004-2005; data for 2007 are used to
represent year 2006-2008.
4. Resul t
Table 1 presents the estimation results, which is quite
consistent with our anticipations. We have the following
Table 1. Dependant variable:
Proln
.
Dependant variables Model 1 Model 2
Constant 6.034951*** 6.157733***
ln B acklink 0.047701**
ln Forlink 0.064076**
ln tran -0.267967***
ln btran 0.077903**
ln rnd 0.162076***
ln brand -0.013762
ln sale 0.245397***
ln bsale 0.062997***
ln Cap 0.466369*** 0.327844***
ln
Size
0.148883** 0.284671***
ln AR(1 ) 0.898923*** 0.903330***
Fix ef f ects
1--C 0.360211 0.312150
2--C -0.252174 -0.089820
3--C -0.582144 -0.547706
4--C -0.233206 0.160792
5--C -0.538998 -0.193214
6--C 0.296038 0.782074
7--C -0.001599 0.179099
8--C 0.035685 0.594953
9--C 0.904339 0.754525
10--C 0.060737 0.179189
11--C 0.371601 0.238329
12--C 0.091197 -0.618255
13--C 0.082510 -0.047681
14--C -0.594732 -1.381561
15--C 0.000534 -0.322864
R2 0.994580 0.998631
Adjusted R2 0.993369 0.997756
F statistics 820.9578 1141.658
D--W statistics 2.488180 2.974735
Prob(F-statistic) 0.0000 00 0.000000
Note:***, ** represent 1% and 5% significance
findings: First, both forward and backward linkage ef-
fects between FDI in services and manufacturing sectors
are positive and significant, which indicates, on the one
hand, services FDI can enhance manufacturing labor
productivity through providing services inputs to the
manufacturing secto rs. O n the o ther ha nd, ma nufac turin g
efficiencies can also be enhanced when manufacturing
firms provide inputs to Foreign Service firms, probably
because foreign service firms set higher standards for
their inputs, which force manufacturing firms improve
their output. Secondly, we find that overall forward lin-
kage is stronger than back ward linkage. FDI in transpor-
tation, storage and communications has a substantial
negative forward linkage effect on manufacturing effi-
ciencies, but the backward linkage is positive. The nega-
tive forward linkage is inconsistent with anticipation,

FDI in Services and Manufacturing Efficiencies in Host Countries: Evidence from China
180
possibl y because there is still substantial barr ier blocking
foreign investment in the industry, especially in areas
like railroad transportations, basic communications and
postal services. The positive backward linkage is easy to
understand considering the substantial inter-industry
connections with this industry. FDI scientific research
and c ompr ehe nsi ve tec hno log ic al ser vice s ha s sub sta ntia l
positive forward linkage effect with manufacturing in-
dustries. They provide research and development, which
could be direct input into manufacturing sectors, helping
improve manufacturing efficiencies. FDI in retailing and
wholesaling services presents the most substantial in-
ter-industry linkage effects with manufacturing sectors.
Both forward and backward linkages are substantially
positive, and the combination of the two is the biggest
among all the service industries examined. In Chinas
service sectors, retailing and wholesaling is the most
open to foreign investment, thus the linkage effects is
easier to be realized. Retailers and wholesalers are dis-
tributions channels of manufactured goods, which deter-
mine the product availability, sales efficiencies and cus-
tomer services. With more experienced logistic manage-
ment and better technologies, foreign distributors, espe-
cially multinational distributors, provides better services.
On the other hand, by providing input to foreign distrib-
utors, manufacturing companies efficiencies are im-
proved, probably because of the higher requirement and
more intense competition i n multinational distr ibutors.
5. Conclusions
The paper first theoretically analyses the influences of
FDI in services on efficiencies of manufacturing sectors
in host co untries, then studies the forward and backward
linkage effects of FDI in services on manufacturing sec-
tors with an industry panel data in China. We find both
positive forward and backward linkage effects exist be-
tween FDI in services and Chinese manufacturing effi-
ciencies. FDI in retailing and wholesaling industry has
the most substantial inter-industry linkages. The finding
implies that we need to have a comprehensive under-
standing of the significance of service liberalization,
which can not only boost the development of local ser-
vice sector by injecting more completion and demonstra-
tion effects, but also benefit the efficiency in manufac-
turing sect ors through inter-industry linkages.
The study is preliminary for the following reasons.
First, due to data availabili ty proble ms, the study d oesn ’t
precisely capture the input-output relationship between
FDI in services and manufacturing sectors in host coun-
tries. If we can get service output data and input-output
data for more years, the empirical study will be more
convincing. Moreover, many other channels where FDI
in services influence manufacturing industries in host
countries is not studied in this paper, for example, FDI in
services and export of manufactured goods, interaction
between FDI in services and in manufacturing sectors,
which also give space for future research.
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