Effect of Environmental Regulations on Foreign Direct Investment: Empirical 2 evidence from China

: 41 The industry selection effect arising from the impact of environmental regulation on 42 Foreign Direct Investment (FDI) in China is heterogeneous. Based on an extension of 43 the principal-agent Game Theory, this paper constructs a system of simultaneous 44 equations to study the dynamic effect of environmental regulation on Chinese FDI in 45 terms of industry selection decisions, by utilizing panel data from 2005 to 2014 in 46 China. Results of this study show that environmental regulation promotes the 47 technological innovation within the Chinese industry and attract greater foreign 48 capital investment. While the influx of capital will furthermore boost technological 49 progress, a benign interaction effect may be observed between technological 50 innovation and foreign capital. The implementation of the new environmental policy 51 will intensify game strategies between managers and enterprises. Enhanced 52 co-ordination activity within industrial organizations will generate more effective 53 organizational and technological innovation, thereby attracting a large flow of FDI, 54 Phase analysis suggests that the policy of market borrowing technologies is more 55 effective. In addition, industry sample results highlight a compensation effect of 56 technological innovation in the raw materials and manufacturing industry, though 57 environmental regulation of high-tech industries will generate an offset effect with 58 respect to technological innovation. Industries that show the strongest technological 59 and innovative prospects will prove the most attractive for foreign capital investment.

Introduction 64 regulation will increase the cost of pollution control for enterprises. As such, Brand 126 and Taylor (1997) highlighted that companies operating within countries with lower 127 environmental standards benefit from cost advantages, and specialize in the 128 production of pollution-intensive products. In some developing countries, 129 governments may actively seek to reduce environmental standards to attract foreign 130 direct investment, thereby transforming the country into a 'pollution paradise'. Zarsky

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(1999) suggested that to attract FDI through reduced environmental regulation 132 standards, which encourage a race on the part of developing countries to attain the 133 lowest environmental standards, environmental regulation has in fact inhibited the 134 flow of FDI to regions with higher environmental regulation. Some academics who 135 support the pollution haven hypothesis believe that environmental regulation has a 136 significant negative impact on the location selected by new companies. For example, 137 Garofalo and Malhotra (1995) and List et al. (1999) supported the findings of 138 investment research examining the US industrial sector and manufacturing companies. 139 Cole and Elliot (2005) found that capital abundance and lower environmental 140 regulation standards constitute two conditions for the formation of pollution havens. 141 Based on panel data from the US from 1977 to 1994, Keller and Levinson (2002) 142 found that environmental regulation has a significant negative effect on FDI inflows.   Foreign-funded enterprises are faced with changes to the host operating environment, 228 including host industrial policies, the host economic scale, and degree of 229 marketization of capital inflows. All these changes will influence the management 230 cost.

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In light of such variables, the current paper seeks to address the foregoing issues.

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This study may offer novel insight into three particular issues. First, based on the 233 extended game model of principal-agent regulation, the present study constructed a   managers is denoted by (1) in the production chain.
(1) 284 We assumes that, under the effective production level, the production number The first two conditions (3) and (4) are prior participation restrictions to ensure 318 that the manager has limited liability. The latter two conditions (5) and (6)are 319 incentive compatibility conditions, which stipulate that the manager prefers to report 320 true private information (i.e., technical costs). Define the R&D investment with respect to the marginal income from the enterprise's 327 investment: Enterprises prefer to pay information rent as the management cost, which 328 is denoted by U I and shown by equation8 ∈ .
There are two differences between the non-regulated game and the regulated 331 game. First, within the regulatory game framework, the manager must simultaneously (3)The enterprise's R&D investment R I satisfies equation9.
The following is a summary of the foregoing theoretical analysis:

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The firstly, according to the regulatory game framework, as output shown by equation (11).
The aforementioned formula can be expressed as equation (12). The left side of the 375 inequality expresses the information rent saved, and the right side denotes the 376 enterprise's lost profit at existing environmental regulatory conditions. Since   , qh  377 15 is concave, i.e., *0 hh qq  , producing equation (13), , then equation (14) is obtained.
Until this point, there has always been sufficiently low or marginal environmental 382 pollution to satisfy the above inequality.  logarithm processing method for the latter empirical analysis of data.
In the aforementioned formulas, industry is denoted by , and the period is      variable that which excludes two predecessors, and the system of equations is 519 over-identified. Therefore, this study aimed to develop a full-sample, sub-period, and   show that environmental regulation, management costs, and foreign capital exert a 632 significant and positive impact on R&D and the flow of FDI from the Table 3 results.  were compiled using output from Stata 12.0 SE software.  innovation. This is due to the fact that the Chinese high-tech industry produces an

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Efficiency often comes at the cost of robustness. The 3SLS method is more 779 effective than other methods though lacks robustness. Therefore, this paper revisits  Among them, UEij denotes the pollution emission of j pollutants in industry i.