The Impact of Foreign Direct Investment on Firms’ Cash Holdings: Evidence From China

Summary

This paper uses Chinese firm-level data (annual survey of industrial firms, 1998–2007) and exploits the 2002 FDI liberalisation as an instrumental variable to identify the causal effect of foreign direct investment (FDI) on manufacturing firms’ cash holdings. The core finding: a 1% rise in industry-level FDI is associated with an average 7.10% decrease in firms’ cash holdings. The authors test two mechanisms — investment squeezing and alleviation of financial constraints — and find both contribute to the decline in cash holdings. Notably, vertical (upstream) FDI increases cash holdings, while horizontal FDI drives the overall negative effect. Heterogeneity analysis shows smaller firms, private firms and firms in more competitive industries experience the largest reductions.

Key Points

Data: Chinese annual survey of industrial firms, 1998–2007; instrument: 2002 FDI liberalisation.
Main estimate: a 1% increase in industry-level FDI reduces firm cash holdings by 7.10% on average.
Two mechanisms identified — investment squeezing (domestic firms cut cash because FDI crowds out investment opportunities) and easing of financial constraints (access to external finance improves) — both lower cash holdings.
Vertical FDI from upstream industries has the opposite effect and raises firms’ cash holdings.
Effects are concentrated among smaller firms, privately owned firms, and firms in highly competitive industries.

Content Summary

The authors apply an IV strategy based on the 2002 liberalisation shock to address endogeneity in FDI placement. They document a substantial negative relationship between industry-level FDI inflows and domestic firms’ liquidity buffers. The paper explores economic channels and provides robustness checks, distinguishing horizontal versus vertical FDI and conducting subgroup analyses by firm size, ownership and industry competition. Supplementary material and references support the identification strategy and interpretation.

The dataset is not publicly available but is obtainable from the corresponding author on request, subject to privacy restrictions. The authors declare no conflicts of interest.

Context and Relevance

This study connects two major literatures — FDI spillovers and corporate cash holdings — delivering causal evidence from a major manufacturing economy. For policymakers, the result implies inward FDI reshapes domestic firms’ liquidity needs and investment behaviour; for firm managers and financiers, it signals how foreign entry can alter cash management and access to external finance. The distinction between horizontal and vertical FDI is especially relevant for industrial policy and for firms evaluating the risk/benefit trade-offs of foreign competition versus supply-chain integration.

Author style

Punchy: solid causal design, clear magnitudes, and actionable heterogeneity. If you care about firm finances, industrial policy or FDI impacts in emerging markets, this is important reading — the results change how you think about liquidity risk after foreign entry.

Why should I read this?

Quick take: if you’re into FDI, firm finance or China, read it. It uses a clean natural experiment to show foreign investment doesn’t just bring tech and jobs — it materially changes how much cash domestic firms hold and why. Handy for anyone making policy or lending decisions in manufacturing sectors.