The Role of Institutional Quality in Chinese Outward Foreign Direct Investment and Domestic Investment’s Impact on Economic Stability

Capital flow, integral to the global economy, is significantly influenced by business potential and institutional environments. As one of the world’s largest economies, China’s outflow plays a crucial role in the rapid development of its economy. This study examines domestic investment into public and private components to avoid aggregation bias, whether China’s outward foreign direct investment (OFDI) serves as a substitute or complement to local investments, and how local institutional quality mediates this relationship. We employed Dynamic Autoregressive Distributed Lag model ARDL simulation methods for the period of 1996–2021 in order to control endogeneity, auto-correlation, cross-sectional bias, as well as heteroscedasticity issues, which normally arise in time-series datasets. Our findings reveal that OFDI has a dual impact on local economies. Firstly, OFDI has a generally positive effect on private and public investment, but this relationship is nonlinear. Furthermore, institutional quality significantly influences private investment more than public investment. Additionally, higher interest rates are shown to adversely affect both private and public investments by increasing borrowing costs. These results offer valuable insights for policymakers aiming to optimize investment flows and economic stability. Specifically, fostering institutional quality can amplify the positive spillovers of OFDI on private investment, while mitigating its crowding-out effects on public investment.