Received internationalization theory argues that firms occupy domestic space before going abroad; in other words, large, oligopolistic firms are most likely to internationalize. The experience of China, whose economy is fragmented and whose firms are small by global standards, suggests otherwise. We construct a model of small firm internationalization driven by the relative transaction costs of crossing domestic (in the case of China, provincial) and international borders. When the costs of crossing domestic borders exceed the costs of crossing international borders, firms will internationalize at a relatively early stage of development. In the case of China, local protectionism and inefficient domestic logistics increase the costs of doing business domestically; moreover, protection of property rights in the West and the advantages afforded Chinese owned firms reconstituted as foreign entities operating in China decrease the costs of ‘going out’. We coin the term ‘institutional arbitrage' to capture Chinese firms’ pursuit of efficient institutions outside of China. We argue that strategic exit from the home country rather than strategic entry into foreign markets may explain the internationalization of many Chinese firms.