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5.1 INTRODUCTION As one of the world’s fastest growing economies, China has attracted a large amount of FDI over the last two decades and, since 1993, has been the largest FDI recipient amongst the developing countries. The amount of FDI inflows into China totalled US$488 billion 1 during the period 1988–2003, with approximately 271 963 MNEs operating in China. Does this enormous amount of FDI in China crowd out domestic investment or complement it? Answering this question is important because a complementing relationship means a beneficial effect of FDI on growth irrespective of time horizons. Otherwise, FDI may be detrimental to economic growth in the long run if not in the short run. Despite a large amount of literature on the subject, the role of FDI in economic growth remains highly controversial. The proponents of FDI argue that FDI helps promote economic growth through technology diffusion and human capital development (Borensztein et al. 1998; de Mello 1999; Kim and Seo 2003; Liu et al. 2002; Shan 2002a; Van Loo 1977). This is particularly the case when MNEs in a host economy have vertical inter-firm linkages with domestic firms or have sub-national or sub-regional clusters of inter-related activities. Through formal and informal links and social contacts among the employees, MNEs diffuse technology and management know-how to indigenous firms. Consequently, economic rents are created accruing to old technologies and traditional management style. Also, FDI helps overcome capital shortage in host countries and complements domestic investment when FDI flows to high...