International Economics

China, which traditionally has been described as a slumbering dragon, is one of the most popular investment destinations in the world, attracting Foreign Direct Investments (FDI) at a most astonishing rate. This inevitably has created a myriad of questions regarding this phenomenon, to which this paper attempts to answer, with regards to how China actively liberalized FDI ,the characteristics of FDI in China, the challenges of investing in China, which will be amply illustrated through case studies, the impact of this large inflow of FDI, and lastly, how we think China can do to rectify some of its existing problems with regards to FDI.

Liberalization and Characteristics of FDI in China Since late 1978, China has carried out massive economic reforms in an effort to restructure their economy to be more market-oriented, with FDI being one of the pillars of this reform. The government has gradually liberalized its restrictions on FDI in order to reap to reap the benefits of foreign investments, such as technology transfer, modern management skills, and foreign exchange. The results of these reforms have been extraordinary, with thousands of multinational companies (MNCs) having invested in China, brining with them billion of dollars in FDI (Appendix A). By the 1990s, China has become the second largest FDI recipient in the world.

China revised their laws and regulations in order to allow FDI and to entice MNCs to invest. China’s first move to open up its economy to FDI was taken with the implementation of the Sino-Foreign Equity Joint Venture Law. This allowed the legal entry of FDIs into China and provided a statutory basis for the establishment of joint

ventures with China. Foreign companies seeking investments in China will have to set up a “joint venture” with a local Chinese partner, in which the profit and risk sharing of equity joint ventures is proportionate to the equity of each partner. An equity joint venture is usually structured as a limited liability company with the foreign partner contributing a minimum of 25% of the registered capital, subjected to the approval of the Chinese Ministry of Commerce. Investments were only allowed in designated Special Economic Zones (SEZs). These SEZs were located in Guangdong Province, Fujian Province, Hainan Province, Hunchun and the Pudong Development Zone (Shanghai). The benefits of investing in a SEZ come mainly by tax incentives. A typical example of the tax concessions offered to a manufacturing startup typically looks like: •

No tax during start-up years before making a profit

•

The first year that your company makes a profit starts the "Tax Clock" and is year one

•

The first and second year after the tax clock starts, there is no tax.

•

For years three and four, there is 1/2 of the normal tax rate.

•

In the fifth year, the company pays the full normal tax rate.

Hong Kong and Taiwan remain are the two main sources of FDI to China (Appendix B). However, the importance of these 2 economies diminished somewhat in the 1990s as MNCs from Europe, Japan and the United States entered China. However, these 2 economies still account for almost half of FDI in China. In terms of sectoral distribution of FDI, manufacturing makes up the largest portion (Appendix C), contributing up to 60% of FDI, followed by real estate with 24 %. Within the manufacturing sector, almost

half of it is directed towards labor-intensive manufacturing, suggesting foreign companies’ motivation to tap into China’s low labor costs.

Challenges of FDI in China Foreign firms who are weighing a decision to invest in China, as well as those who already have engaged in FDI, face a number of potential problems. The challenges listed in this paper are by no means exhaustive. The complex bureaucratic structure of China’s government brings about certain problems. A potential problem is misreporting, which makes it difficult for companies to assess rates of returns due to the questionable nature of China’s official macroeconomic data. Because of China’s large population, coupled with the complex governmental structure from village level all the way to the national level, collating data is highly inefficient and inaccurate. Moreover, local authorities tend to exaggerate their achievements and conceal their losses in a bid to impress their superiors. The many layers of government also gives birth to a lot of red tape, among which is a rather complicated application process for new investments, which hinders prospective investors. Also, China, being a large country with a population of 1.3 billion people, has a very diverse culture. Commonly, people often cite Chinese as emphasizing on guanxi, or interpersonal connections, as a way to do business. However, the truth is that there are many different interpretations to that among all the different provinces, due to differences in lifestyle, upbringing and circumstance. Investors must take note of these differences in demographics as they can have a profound influence on businesses. There is also a lack of infrastructure and industrial tradition in some areas, which, inevitably, leads to problems in the daily running of the business, such as, lack of utilities (water,

electricity). These disruptions in basic amenities can be costly as the productivity lost can be significant. Corruption, for example bribery, is also an obstacle that potential investors have to grapple with. China was ranked 59 out of 150 countries in the World Democracy Audit for 2003. A high perception of widespread corruption will scare away potential investors, and hinder businesses already in operation there. The cases below further illustrate, and add on, to the challenges as discussed. Case Study 1: Chinese Car Makers Set Sights Overseas For many years, China has been the main breeding grounds for many models of automobiles. These companies formed lucrative partnerships with foreign companies who set up plants in China and tapped on the cheap labor resources there. However, after serving as apprentice to foreign automobile makers for the past decade or so, some big state-owned Chinese car companies are trying to expand their diminutive stature overseas and building their own brands. The years of service to the big names in automobile business have taught the Chinese invaluable experience and path a more smooth-sailing way forward for them. From technology behind the assembly plants to management of the different sectors, Chinese companies have learnt their lesson well and are now venturing into their own hands-on session. The sole aim of the companies is to build their brands overseas and help China claim more than a few familiar brands to foreigners. After all, being a country that has enjoyed two decades of near-double-digit growth, China’s policy makers are eager to take the step in this highly competitive world and source for their own share in the market.

One company, Shanghai Automobile Industry Corp, has made bold plans to make 50,000 of its own brand of vehicles and clench a seat in the world’s top 10 auto makers by 2010. This may not be a dream come true for the company as they have been gained deep pockets by selling the brands of VW and GM. A spokesperson from SAIC also mentioned the likelihood of acquiring Ssangyang Motor which has the licensed car technology from Mercedes. All such actions points directly to the company’s goals to build up its own brand name and beef up its expertise. Unfortunately, such series of actions could alarmingly disturb the intricate balance of relationships built up between Chinese auto companies and their foreign counterparts. The course of actions could upset the lucrative partnerships and ending several years of marriage in divorce. In actual sense, foreign companies are breeding their own competitors in this automobile chase. Needless to say, if the Chinese automobile makers inched their way into the global market, we would expect much fiercer competition between the once friends. Case study 2: Sponsors Set Stage for 2008 VISA has been one of the world’s preferred credit card companies when traveling and not wanting to carry large amounts of cash. This Athens 2004, officials from the Bank of China were invited to take a tour of the historic city and witness for themselves, not the beauty of the architecture and landscaping, but rather the convenience and popularity of VISA cards when purchasing items. This is an act to try to encourage Chinese banks to get local restaurants and stores wired to their cards. China has 3 million VISA cards that are allowed to be used abroad and VISA is hoping that the number would increase to 50

million by 2008. However, with only about 10% of merchants utilizing this mode of payment now, VISA has a long great wall to climb to its target. Case Study 3: China’s Retailers Feel the Heat This year, China’s surging power shortage problem in summer has forced restaurants, shops and even hotels to survive the long and dreadful sauna-like temperatures without 24 hour air cons and even blackouts during peak periods. Many restaurants have to turn away the lunch-time crowd as they lack the electricity to produce food catered for the needs of the consumers. Even factories have to delay productions or change to production at night to cut down costs. The same luxury is not applicable to retail businesses that cannot shift their businesses to opening at night. Many customers have to turn away from shops that have been suspended electricity due to high consumption. Sometimes, customers are not even able to try on clothes as it is just too hot. Case study 3: China is Far From Being A Free-Market Economy China’s economy is controlled by the ruling party who in turn allocates about half of the fixed-asset investment. Generally, the Chinese business cycle tracks the country’s political cycle closely. The Communist party convenes its national congress every five years and each congress determines leadership changes at both at the top and at the provincial level. The parties derive legitimacy from economic performance and demonstrate their ability by securing jobs and promoting growth. However, data has shown that the growth rate in the year when a party congress is convened is significantly higher than in the preceding year. In 1992, the growth rate was 14.2%-5% higher than the 9.2% registered in 1991.

Political leaders have the power to dramatically increase fixed-asset investments as they have the access to bank credit and other forms of capital. Although the state owns 4 dominant commercial banks, it is the provincial leaders who dictate their lending positions. Thus, the provincial leaders have the final say in the pet projects and even the future of the managers in the provincial branches. Few people would dare deny credit to these local strongmen for fear of facing a sack. The typical solution adopted by the Central government is to tighten the reins on these leaders first without serious warnings. If things continue its spread this way, a few pin pricks like canceling a project would server as a warning to the leaders. Only when such tinkering efforts fail does Beijing announce a full procedure to punish the leaders like stripping them of their titles or even freezing strict limits on investments. These measures only goes to show that China still has a long way to go before genuinely becoming a free market as it has to resort to administrative measures and not market forces to slow down its economy. Case study 4: China’s Princelings As suggested by the title, although China has moved forward and tried to clear away the worry of corruption and path a brighter way for investors, when it comes to high-level connections, little has changed since the 1980s. Conventionally, one would expect China not to follow in the type of cronyism similar to Suharto’s footsteps with the opening up of the market and the more robust roles the media have taken upon. However, a closer look at the Chinese economy would surprise many people at how much the tie of crony has jumped by leaps and bounds together with the economy.

Taking Jiang Mianheng, the vice president of the Chinese Academy of Sciences, for instance, besides from getting a university degree from the America like a lot of other aspiring Chinese youths, Jiang has something else which none can compare-his father is Jiang Zemin, the former president and Communist Party chief who still heads the country’s Central Military Commision. Due to this very delicate relationship, the projects that he has been involved in have been enjoying a record of good relations with the authorities. This family tie has made him one of the most popular people to work with among foreign investors. Citigroup formed an insurance venture in June with one of Mr. Jiang’s IT companies-the Shanghai Alliance Investment; Finnish mobile technology firm Nokia sold a 30% stake in its telecoms factory in Suzhou to Mr. Jiang’s Alliance. IBM has sent a delegation of senior executives to meet Mr. Jiang in Beijing in February and even Intel has teamed up with Mr. Jiang’s CAS research arm. Although these giant names have not commented on the family ties that Mr. Jiang has, it is quite likely that ‘brands’ are being recognized here and favored when choosing an investment partner in China. Other examples include the current Party Chief and State President Hu Jintao’s son Hu Haifeng heading the Qinghua University’s Nutech, an x-ray technology company that has been granted major deals for China’s customs checks and immigration security. His daughter Hu Haiqing married Daniel Mao last year who is the founder and director of China’s biggest Internet portal Sina.com, which faces an increasingly competitive and regulated Internet and mobile services industry in China. Premier Wen Jiabao’s son Winston Wen Yunsong is a founder of mainland IT services

company Unihub, which has a joint venture in China with Hong Kong telecoms giant PCCW.

Impacts The influx of FDI due to the market reforms has bought about a plethora of changes into the Chinese society, many of which is good, and some of which is bad. Here we shall examine some of these impacts that FDI has brought about.

China has grown very rapidly since the late 1970s (when market reforms were carried out to allow and attract FDI) and statistics proves it. The average annual GDP growth from 1998 to 2002 is 9.5%, while per capita GDP rose from $300 in 1980 to $1000 in 2002. FDI has contributed to GDP in various ways. FDI contributes to GDP by adding to capital formation. This effect is estimated to have contributed as much as 0.4% to average annual GDP growth in the 1990s. The direct contribution of FDI to GDP is the highest in provinces such as Guangdong (which is a SEZ) as they attracted the most FDI. FDI has also contributed to GDP through its positive effect on Total Factor Productivity (TFP). TFP is the measurement of how well an organization utilizes all of its resources, such as capital, labor, materials, or energy, to produce its outputs. Empirical research has suggested that FDI has raised TFP growth by 2.5% annually in the 1990s. FDI has also created employment opportunities, either directly or indirectly, through the establishment of Foreign Funded Enterprises (FFEs). Employment in the FFEs in the urban areas quadrupled between 1991 and 1999 to a total of 6 million, accounting for 3% of urban employment. In the coastal provinces of Guangdong and Shanghai, FFEs account for a

much as 10% of urban employment. This spurt in growth in GDP has bought about a reduction in poverty in China. An estimated 200-400 million people were lifted out of poverty from 1980 to 2002, and according to the World Bank, much of the reduction in global poverty during the last 2 decades was accounted for by China. Thus we see improvements in the standard of living of the Chinese as a whole.

However, due to fact that FDI has been concentrated on the coastal regions and this hs created a widening disparity in income. This enlarging income disparity is significant because it can retard efforts to reduce poverty, and also inhibit economic growth. Also, large income disparity leads to social problems such as a higher incidence of crime and political instability.

Analysis As discussed above, there are some teething problems which have resulted from the influx of FDI in China, and we shall attempt to provide solutions to these problems.

Income Disparity The income disparity between the coastal and inland regions is an urgent problem which has to be dealt with. As the disparity is largely due to the attractiveness of the SEZs in attracting FDI than the inland regions, we propose that China open up those other areas too, by providing support for infrastructure and amending the law to allow for FDI to operate in those regions. Basic infrastructure as such the transport and communication system should be developed such that businesses can operate there with efficiency.

Empirical studies confirm that provinces in china with more superior infrastructure and transport links to external markets tend to receive more FDI. Similarly, China can provide tax incentives for investments in the inland regions too, as this is mostly the main appeal for investments in the SEZs.

Over-reliance on FDI As above, manufacturing makes up the bulk of China’s FDI, and this underscores China’s heavy reliance on this sector. Thus, if this sector is to undergo a recession, China’s economy could be adversely affected. Thus, China should not rely heavily upon the manufacturing sector for its prosperity forever. It should diversify its efforts to other sectors such as R&D and agriculture. China’s competitive advantage is its abundant supply of natural resources. China is one of the world’s biggest fishery and farming countries, with its aquatic products accounting for 70% of the world ones. The agricultural sector deals with providing staple foods for people and thus is able to command a high profit if it were to export extensively overseas. However, its agricultural export in the year 2002 was merely

. If China were able to step up its production

capacity, it would have been able to earn a lucrative profit from the recent Bird Flu crisis. Thus, China should make full of this competitive advantage and design methods to further improve on the agricultural sector. Our group foresees the great potential in expanding the product export with its first place position in China's agricultural product exports presently. It might even become the world’s leader in agricultural supply in the future.

So what is hindering China from speeding up its export volume? We believe that the lack of advanced technology may be one of the reasons. Instead of its productivity increasing, it has been showing a downward trend in recent years. Such trend might be owed to the decreasing number of labor working in this industry. Internal migration of labors from rural to urban regions has been accelerating ever since the accession to WTO. Thus, China is now attempting to substitute advanced technology for labor to boost productivity in this sector. The main tasks are to have a great increase in high-quality breeding and its product processing, to have an effective control in aquatic and animal diseases and to have a remarkable increase in the export proportion of agricultural products by attaching the importance to the three key sectors including product quality and safety, breeding and fine processing. According to the commitments after China's accession to the WTO, the average tariff level of China's agricultural products will also be reduced from the present 19.9% to 15.5% in 2005. China’s over-reliance in FDI might affect the economy negatively if the investors decide to pull their investments out of the market overnight. Singapore is a good example of this. Neighboring countries such as India which shares with China many of the structural factors that have been important determinants of FDI- market size, abundant labor, and a large Indian Diaspora might become an attractive destination for FDI in the next 10 years if the Indian government decides to impose a vision for the path of development and growth of the country. To avoid such crisis from realizing in the future, our group feels that China could encourage existing high performing Chinese companies to switch their focus overseas. A recent case would be the Shanghai Automotive Industry Corp., the invisible spouse for two of the world’s biggest car makers, Volkswagen AG and General

Motors Corp. It has moved its global expansion into high gear. It has entered talks to partner with Britain’s MG Rover Group Ltd., the sports-car maker. This month, it announced aims to acquire Ssangyong Motor Co., South Korea’s fourth-biggest car maker, potentially making it the first Chinese auto maker to take over a foreign counterpart. In addition, China could also encourage entrepreneurship among the Chinese citizens. With the market dominated by mainly the Chinese enterprises, it would not have much effect on the economy if the FDI moves to other countries. Presently, many countries such as the United States of America and Japan are outsourcing their production to China. This creates a great opportunity for the Chinese to expose to the foreign management styles as well as the standard of quality set by the foreign companies. Thus, by integrating the valuable knowledge acquired from the foreign companies into their own expertise, it might create a competitive advantage for them. Currently, China is taking an increasingly active view in the formulation of global technical standards. According to the report, as a world leader for manufacturing and consumption of high-tech products, China has a strong influence over domestic and global market standards. As Chinese standards become more widely accepted, Chinese enterprises will see a rise in standing in the global technological sector. Yan Louyou, Chinese

Chief

of

the

service

group

for

DTT

Technologies,

Media

and

Telecommunications, argues that global technology and telecom firms need to valuate Chinese standard proposals and, when appropriate, set up technical standards in conjunction with Chinese enterprises. The report predicts Chinese manufacturers will first

build up a strong business support team in China and then export their technologies to emerging markets in Southeast Asia and Middle East. China’s formulation of global technical standards acts as a branding to the products manufactured by the Chinese companies. This paves a smoother path for future emerging Chinese corporations to expand their diminutive stature overseas.

Conclusion China has made great strides in its reforms to open up its market for foreign direct investment. Among developing countries, China is now the largest recipient of foreign capital. Foreign direct investment is still concentrated in the southeast and the coastal areas, even though we see a slow process of diffusion. Foreign-invested firms have played an increasingly important role in Chinese economic reform. However, there remains many challenges to investing in China to which it must tackle in order for it remain an attractive destination for FDIs. FDIs has also resulted in problems to which China must try to alleviate.

References: •

http://www.qis.net/chinalaw/prclaw11.htm

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http://chinaunique.com/business/sez.htm

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http://www.worldaudit.org/corruption.htm

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Wall Street Journal, 19th August 2004

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http://www.fdi.gov.cn/lteconomy/index.jsp?app=00000000000000000005&language=en &category=¤tPage=1

•

Sizing up FDI in China and India, Shan-Jin Wei, Stanford University, December 2000

•

Wall Street Journal, 20th August 2004, front page

•

ibid, Page A5, Column 4

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ibid, Page A5, Column 5

•

Wall Street Journal, 24th August 2004, front page & page A7, Column 1

•

www.WSJ.com

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Wall Street Journal, 25th August 2004, front page

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http://www.weforum.org/site/knowledgenavigator.nsf/Content/Is%20China%20a%20For eign%20Investment%20Goldmine%20or%20Minefield%3F_2004?the

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Wall Street Journal, 28th August 2004, Page A12, Column 3

•

Wall Street Journal, 2nd September 2004, Page M8 Column 1

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ibid, Page M8, Column 2

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ibid, Page M8, Column 2-3

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http://www.wider.unu.edu/publications/pb4.pdf

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China to Become A Major Parameter for Global Technical Standards, 2004-08-18, http://www.fdi.gov.cn/common/info.jsp?id=ABC00000000000016107 http://www.fdi.gov.cn/lteconomy/index.jsp?language=en&app=00000000000000000010

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&category=01¤tPage=1

• •

http://www.edu.cn/20020709/3060913.shtml The Asian Wall Street Journal, 31/8/04

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The Asian Wall Street Journal, 24/8/04

Appendix A:

Appendix B:

Country/Region Hong Kong* Japan USA Taiwan** Others Total Contracted Investment

19791989 20,879 2,855 4,057 1,100 4,569

1990

1991

1992

1993

1994

1995

1996

1997

3,833 457 358 1,000 1,948

7,215 812 548 3,430 3,405

40,044 2,173 3,121 5,543 7,241

73,939 2,960 6,813 9,965 17,759

46,971 4,440 6,010 5,395 19,864

40,996 7,592 7,471 5,849 29,374

28,002 5,131 6,916 5,141 28,086

18,220 3,400 4,940 2,810 22,410

% Change -35% -34% -29% -45% -20%

32,360

7,596

11,980

58,122

111,436

82,680

91,282

73,276

51,780

-29%

Graphical Representation:

7%

Appendix C: